Fed’s upcoming interest rate hike will impact credit card rates

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After months of targeting a practically 0 percent rate, the Federal Reserve started to raise its target interest rate in March, taking it up to the 0.25 percent to 0.5 range. And the market anticipates that the U.S. central bank will follow up with a steeper 50 basis point rate hike at its May meeting. That would take its target rate to the 0.75 percent to 1 percent range.

What’s more, the Fed will likely follow up with a series of rate increases this year. The impact of the Fed’s actions is likely to filter down to credit card holders, and you should be prepared to see your variable card rates start going up.

The Fed’s 0 percent rate was intended to provide support for the economy and easier credit access to consumers and businesses to combat the impact of the pandemic. With the worst of the pandemic behind us and inflation starting to appear—in January, the Consumer Price Index rose 7.5 percent over the year (its largest gain since February 1982) and inflation rose 8.5 percent in March—the Fed is now focused on hiking its targeted interest rate to remove support for the economy.

While the geopolitical impact of Russia’s invasion of Ukraine has added some uncertainty to the outlook, the Fed has not shied away from its tightening. Actually, the fallout of higher oil prices that could further fuel inflation, makes a case for the Fed to continue tightening.

Support during the pandemic

When the coronavirus pandemic made an appearance in 2020, the Fed started watching the situation closely. It made two interest rate cuts in March outside of its scheduled meetings, bringing its target rate down 1.5 percentage points to practically 0 percent.

This low rate was aimed at spurring consumption and business investment to keep the economy’s wheels greased as it recovered from the crisis.

The Fed also stepped in to purchase mortgage-backed securities and Treasury securities, thus pumping money into the economy and lowering interest rates. And it took additional measures to prevent financial markets from freezing up.

Employment and inflation goals

Now that the economy has recovered sufficiently, the Fed has started raising its target rates to combat inflation. The Fed’s actions are guided by its dual mandate of managing both employment and inflation (so as to achieve price stability) in the economy. Its aim is to shoot for maximum employment while letting inflation run at 2 percent in the long run.

As of March, the U.S economy added 431,000 jobs, and unemployment was at 3.6 percent. Back in 2020, in an asymmetric inflation targeting, the Fed decided it was comfortable not raising its target rate even if inflation went past its 2 percent target for a while. After all, inflation had run below this 2 percent rate for several years.

The Fed decided it would keep rates low—even as employment rose—to make the labor market more inclusive and allow disadvantaged populations to get jobs, keeping in mind lessons learned from the last downturn (when inflation did not rise even though employment continued to grow). It seemed the Fed would not start raising rates until 2023.

In Congressional testimony earlier in March, Fed Chair Jerome Powell said the Fed’s expectation is that inflation will peak and start coming down this year. However, with inflation crossing the 7 percent threshold for a few months, the Fed will continue to raise rates. It believes the labor market can withstand the impact of its rate hikes.

In 1980, inflation under then Fed Chair Paul Volcker reached 11 percent. With that lesson in mind, the Fed is now focused on acting preemptively before the inflation situation gets out of hand.

What will the Fed do?

Considering inflation has been rising, the FOMC will likely continue raising its target rate in its upcoming meetings. In a public speech in April, Lael Brainard, a Federal Reserve governor, said the Fed will continue with a series of rate increases and sell off its balance sheet holdings more rapidly (thereby sucking up money from the economy) as soon as its May meeting. The Fed has already started to wind down its purchases of securities.

“I expect the combined effect of rate increases and balance sheet reduction to bring the stance of policy to a more neutral position later this year,” Brainard said, “with the full extent of additional tightening over time dependent on how the outlook for inflation and employment evolves.” A neutral interest rate is one in which an economy achieves its potential (with full employment) while prices remain stable.

Impact on credit card interest rates

What all this means for cardholders is that you are likely to see a hike in your variable card rates. These rates are tied to the prime rate. The prime rate, in turn, is based on the Fed’s target interest rate. This means when the Fed starts hiking its target rate, the prime rate will also go up. And when the prime rate goes up, variable interest rates are primed to go up too. In fact, interest rates on credit cards have already moved up slightly, with the national average APR at 16.4 percent at the end of April, from 16.3 percent in January.

That means you should start managing your credit card balances more strategically. If you carry a balance, make plans to pay it off. If you will be carrying a balance for a while, you could transfer it to lower-interest options, such as a 0 percent interest balance transfer offer. You could also think of taking out a personal loan to pay off your credit card if that offers a better deal for you.

The bottom line

The Fed is in the process of ending the easy-money policy it undertook during the pandemic to support the economy. The market expects it to hike up its target rate 50 basis points in May, and continue with a series of rate hikes this year. Since variable credit card interest rates are tied to the prime rate, which is based on the fed funds rate, consumers should be prepared for their variable interest rates to start going up too.