When the fed raised the short-term interest rates on last week, it took about two hours for the credit card companies to raise rates on their customers. Banks increased the prime rate to 8% in a matter of hours, and that difference is already showing up in this month’s credit card statement. Surely this is an efficient market in its full glory.
So how efficient was that market just a couple of years ago? From 2001 to 2003, the prime rate fell from about 8% to 4% (more than 400 basis points for those who thin slice). In the same period, customers realized a rate reduction of about half of that decrease — 2 percentage points (about 200 basis points).
As I read it, this efficient market just created a terrific wealth transfer: 2 percentage points better return than in the pre-2001 days. Perfect markets give way to perfect profits.
The story on Cardrate.com can’t be accessed without a subscription, but the data they report don’t require a lot of explanation. “Since July 2004, credit card interest rates on variable cards has jumped from 11.58% to 16.02%… When the Fed was chopping interest rates between 2001 and 2003, the prime rate fell more than 400 basis points from about 8% to 4%, however, credit cardholders only realized a rate reduction of about 200 basis points. Ironically, during the current tightening, the prime rate has increased 400 basis points and credit cardholders have watched their cards increase by at least 400 basis points.”
Why the difference between rising and falling interest rates? Economists who put their faith in the markets would say that whether the cost of funds is rising or falling shouldn’t matter because all pricing in a competitive market will move to marginal costs. But here’s documented evidence that this isn’t so.
Is it the high degree of concentration within the credit card industry? Is it the fact that once customers are using cards, they are slow to re-shop prices and change cards? Is it the case that credit card companies compete along other lines (frequent flier miles, membership clubs) rather than interest rates?
Whatever the reason for the market failure, what are the policy implications? Profits are way up for credit card companies. When those companies can reap billions of dollars in windfall revenues when costs fall and their prices remain high, that is pretty solid evidence that faith in the perfect market misplaced. Ham-fisted regulations are not the answer, but this is a place for some regulatory inquiry.
I like markets, but when they aren’t working, then government has a responsibility to ask why.
