There’s a subtle cunning to the Federal Reserve’s latest endeavors in tackling inflation. Chair Jay Powell, when questioned about the downturn in inflation, offered a comprehensive defense.
He noted the subsiding impacts of the pandemic and the Ukraine conflict, falling food and energy prices, and a consumer shift back to services over goods.
All these factors were beyond the Federal Reserve’s influence. However, Powell also alluded to their efforts in managing credit demand through rate hikes.
Credit demand takes a hit
Powell’s assertions hold true, particularly when you observe the dip in demand for loans related to homes and vehicles. Since the year’s outset, growth in mortgage debt has nearly halved.
Concurrently, the total value of car loans has shown signs of contraction. In general, growth in non-revolving credit, such as one-time loans like mortgages, teeters just below zero.
However, revolving credit growth, which allows for incremental loans and repayments over time, has seen only a minor drop.
Despite the effective federal funds rate standing over 5 percent, there remains credit growth in the U.S., primarily driven by credit cards. The Federal Reserve’s inflation fight has a specific trick to it, and this is where we begin to uncover it.
Before 2010, home equity lines of credit formed the largest chunk of Americans’ revolving debt. This dynamic has shifted over the past decade, with credit cards becoming the favored instrument for households to maintain liquidity.
The behavior of credit cards has deviated from traditional cyclic norms, exhibiting an unusual pattern over the last ten years.
Historically, as the Federal Reserve tightened its belt, the difference between the federal funds rate and credit card interest rates dipped, offering a late-cycle stimulus to encourage borrowers. The same pattern repeated just prior to the 2008 financial crisis.
However, post-crisis legislation and modifications to Federal Reserve rules restricted the freedom banks had in altering rates. At present, the spread for credit card rates over federal funds has consistently widened.
This makes the trick to the Federal Reserve’s inflation combat even more intriguing.
A debt paradox
The rising role of credit cards, particularly among individuals with lower credit scores and lower incomes, is alarming.
These individuals, commonly referred to as “heavy revolvers”, account for 20 percent of accounts but hold 67 percent of revolving balances, and contribute 72 percent of the banks’ total interest income on cards. Despite higher interest rates, they show no signs of reducing their debt.
This dynamic is essential for banks. Without heavy revolvers, credit cards aren’t profitable for banks due to the high cost of rewards such as cash back or travel points offered to incentivize usage.
The Federal Reserve’s research last year illustrated that high credit score individuals actually profited from rewards cards, while those with the lowest scores lost money. This led to an annual “redistribution” of $15.1 billion upwards, benefiting people with higher credit scores.
For now, the Federal Reserve’s inflation fight continues, with the credit card market playing a crucial, if not entirely predictable, role.
Clearly, this trick to the Federal Reserve’s inflation fight – credit cards – presents a complex situation. As the American economy adjusts to this reality, the coming months will provide an interesting spectacle.
