Heavy credit-card users are key in the Fed’s inflation battle

The writer is an FT contributing editor

Asked this week why inflation was falling, Federal Reserve chair Jay Powell gave a comprehensive answer. First, the worst effects of the pandemic and the war in Ukraine have eased. Prices are down for food and energy, and Americans continue to shift back towards buying services and away from goods. This, he conceded in a roundabout way, was all beyond the Fed’s control. But rate hikes had also reduced demand for credit, he argued. The Fed was doing what it could, and that effort was working. 

Powell pointed out, for example, that demand for home and car loans has dropped. This is true. Growth in mortgage debt has almost been cut in half since the beginning of the year, and the sum of outstanding car loans is shrinking. Overall, growth in non-revolving credit — the loans you take out just once, like a mortgage — is now just below zero. But growth in revolving credit — which you can add to or repay over time — has dropped only slightly. 

With the effective fed funds rate now above 5 per cent, there is still credit growth in the US. It’s coming from credit cards. 

Before 2010, home equity lines of credit were the biggest component of revolving debt for Americans. Since then, however, plastic has become the preferred way for households to hold on to some liquidity. Credit cards have traditionally followed their own cyclical rules, but in the last decade they have started to act a little weird.

In the late 1990s, just as the Fed was hiking, the difference between the fed funds rate and the interest rate on credit cards dipped, narrowing margins for banks as a kind of late-cycle stimulus to encourage borrowers. The exact same thing happened right before the 2008 financial crisis. 

New legislation and changed Fed rules after the crisis, however, limited much of the flexibility banks had in changing rates. To raise or lower margins on credit-card loans, banks had to attract new customers, with a new contract and a new rate. Since then, the spread for credit card rates over Fed funds has consistently widened. At the top of the Fed’s hiking cycles in 2000 and 2007, it was between 8 and 10 percentage points. It is now at 17. 

That isn’t true for everyone, however. Particularly in the US, plastic functions as both payments infrastructure and a source of credit. About 30 per cent of accounts are either new or inactive, and 21 per cent of accounts are transactors — they use the card and pay it off within the month. Almost 50 per cent, however, are either light revolvers or heavy revolvers. 

It’s the revolvers who are paying the higher rates. They tend to have lower credit scores and lower incomes. Banks cherish heavy revolvers, who make up 20 per cent of accounts but hold 67 per cent of revolving balances, and pay 72 per cent of the banks’ total interest income on cards. Heavy revolvers aren’t responding to higher interest rates by backing off on debt because their balances are medium-term loans, not month-to-month choices.

Without heavy revolvers, the cards don’t make sense for banks. Last year Fed researchers looked at portfolio data from the small group of large banks that account for 80 per cent of credit-card debt. Banks collect fees from merchants to accept credit cards for payments. But they also offer rewards — cash back or travel points — to encourage people to use them. Rewards are so expensive for banks that, as a payment medium alone, credit cards only break even. 

That means banks can’t make a profit on credit cards unless they find heavy revolvers. Fed research last year showed that people with the highest credit scores benefit on net from rewards cards, earning more than they pay in interest. Those with the lowest scores lost money on net, creating what the authors called a yearly “redistribution” of $15.1bn upward — towards people with higher credit card scores. 

Use of rewards cards continues to grow, making up a vast majority of all credit card purchases. Credit cards, in turn, account for about a third of non-cash transactions in the US. So a significant part of the US payments infrastructure is essentially a loss leader, a way to find heavy revolvers, or perhaps even convert them. 

The fix for this is beyond any decisions that the Fed’s Open Market Committee can make in its monetary policy meetings. An act introduced in the Senate in June — not for the first time — would direct the Fed to open up the market for credit-card payments processors, beyond the dominant Visa and Mastercard systems that banks prefer. This could lower merchant fees, making rewards programmes less attractive to banks. This is of course a political fight; retailers are tired of paying fees to banks. But it’s also a monetary fight. The structure of the credit card market has made a significant part of American consumer credit resistant to rate policy.