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Why the Federal Reserve affects Credit Card Interest Rates

By: Jody Ortiz

We’ve all heard about the Federal Reserve, but what is the Fed really, and how can it affect your credit card interest rates? The Federal Reserve is the central bank of the United States. Its role is to conduct the nation’s monetary policy by influencing the monetary and credit conditions in the economy. This means the Fed has the power to alter the economy. The Fed’s goal in using this power is to achieve maximum national employment, stable prices, and moderate long-term interest rates and to protect the credit rights of consumers, among other things.

The Federal Reserve implements monetary policy through its control over three things. One is the federal funds rate— this is the rate that banks charge each other on overnight loans made between them. These loans are usually made so banks can cover their daily cash flow and reserve requirements. As the federal funds rate rises, banks have an increased incentive to keep more of their own cash on hand – which results in less money available to lend out to households and businesses.

Another is the discount rate, which is the interest rate at which eligible depository institutions may borrow funds directly from Federal Reserve Banks. A third available, but a tool not often used by the Reserve is the reserve requirement. This is the amount of reserves (i.e. money) that the central bank requires a commercial bank to hold (meaning this money cannot be used for loans).

So how does all of this affect our credit card interest rates? Well, if the Federal Funds rate is raised, it costs banks more to borrow money from each other. This increase in cost is passed along to the bank consumers in terms of higher interest rates. That is, the bank charges its customers more to borrow money when it costs the banks more to borrow money. Therefore, they pass along the rising cost to the consumer.

Similarly, if the discount rate is raised, it costs banks and other financial institutions more to borrow money directly from the Fed. This increase in costs is also passed onto the customer. The third option of the Federal Reserve is the reserve requirement. This requirement is usually a specified percentage of their deposits. If the reserve requirement is increased (meaning banks must keep more of their money), there is less money available to be loaned. Less money available means financial institutions can charge more for loans and one way they would do this is through raising our credit card interest rates.

Indeed, financial managers would argue they should raise rates because they’re making fewer loans overall, so if they charged the same amount as usual, their profits would not be as great.