Statements to the Congress - policy statements by members of the Board of Governors Federal Reserve System - Transcript

Federal Reserve Bulletin, Dec, 1991

There is a debate about why credit card interest rates seem to be so stable. One possible explanation of price "stickiness" relates to the differences in consumer behavior or the type of consumer that card issuers encounter as a result of rate increases or decreases. A presumption under this theory is that card issuers face at least two classes of consumers whose behavior makes rate reductions unattractive even when funding costs decline. The first class of consumers do not intend to borrow on their accounts, but instead, maintain credit card accounts primarily for convenience. Although these convenience users may unexpectedly borrow at high rates, their use of credit is not responsive to changes in interest rates. They are valuable customers for the bank because they may be better credit risks and unlikely to respond to interest rate changes. The second class of consumers fully intend to borrow on their credit card accounts and are therefore more responsive to rate changes. These consumers may, however, be less attractive credit risks.

Because a reduction in rates will attract few of the more creditworthy consumers but perhaps will attract many consumers that could cause losses from deliquency or default, this theory proposes that issuers faced with these results will be reluctant to reduce rates in response to reductions in funding costs. This theory is somewhat controversial because it assumes persistent irrational behavior on the part of a class of consumers.

An alternative explanation offered for the stickiness in rates assumes that established credit card issuers have a solid customer base that does not change its use of credit cards in response to changes in interest rates because of the costs of searching for, and switching to, another card provider. These cost include the following: (1) the time and effort to identify a more attractive credit card and to complete a new credit card application, (2) the potential effect of having a credit rejection added to a credit bureau report, (3) the possibility of a reduced credit limit with the new issuer, (4) uncertainty about the quality of service with a new card issuer, and (5) uncertainty about future rates and fees. Also, the potential savings in interest costs from switching from a high-rate issuer to a low-rate issuer may not be substantial. Because the average balance outstanding for those consumers who regularly borrow is approximately $1,500, a reduction in credit card rates from, for example, 20 percent to 16 percent is likely to save the consumer about $60 per year. I suspect that for many consumers this potential savings is not sufficiently great to overcome the convenience of retaining their current accounts and the costs of changing accounts.

If credit card issuers perceive that the demand for their credit cards is not very sensitive to interest rates, they may have little incentive to adjust their rates rapidly to changing financial conditions. This is particularly true if, in addition, they must incur some costs to change credit card rates (such as costs to advertise, change solicitation literature, and generally inform customers of changes). The gain from changing prices simply may not justify the cost of doing so for those card issuers.