How the Fed’s interest moves have caused CD rates to jump
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BLUEPRINT
Updated 1:24 p.m. UTC June 25, 2024
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It’s been quite the time for savers.
After enduring years and years of near 0% interest rates on cash, you can now easily open a savings account or certificate of deposit (CD) that yields at least 5%, if not more. The reason: Sky-high inflation following economic lockdowns and trillions in stimulus spending caused the Federal Reserve to jack up short-term borrowing costs.
However, the days of ever-higher rates may be over: The nation’s central bank has decided to keep rates unchanged at a range of 5.25% to 5.50% in recent meetings, despite inflation still well above its target level and low unemployment levels.
That’s because price growth continues to grind lower, while wars in Ukraine and Israel, in addition to Fed shrinking balance sheet, has led Fed chair Jerome Powell to hint that rate cuts may occur in the near future.
“Investors were worried that the recent higher-than-expected inflation data would cause the Fed to back off from their projection of three cuts for this year and those fears were unfounded,” said Chris Zaccarelli, chief investment officer for Independent Advisor Alliance.
While high borrowing costs do not bode well for those seeking new mortgages and loans, savers can continue to benefit, at least for the time being.
Fed rate hikes lead to higher CD yields
As the Fed began raising interest rates in early 2022, you were stuck with anaemic yields on your savings. For instance, a one-year CD offered yields of just 0.15%, well below inflation. That’s why so few Americans bothered to purchase a CD.
All that changed after March 2022, though. As the Fed raised short-term borrowing costs, banks increased payouts to its customers in order to attract business. (To be fair, though, CD rates didn’t rise as quickly as the Federal Funds rate.)
Nevertheless, savers suddenly earned decent returns for the first time since the Great Recession. The timing helped offset the damage done by stocks and bonds nose diving in 2022.
What the Fed did at its last meeting
At the most recent meeting that ended June 12, the Federal Open Market Committee kept rates steady at a range of 5.25% to 5.50%, which is still the highest level in more than two decades. The Fed hasn't raised rates since July 2023, and even that move came after no action in the prior meeting.
The Fed's decision comes as the central bank deals with confounding economic and political events.
Take inflation. Using the Fed's preferred gauge (the personal consumption expenditures index that strips out food and energy prices), prices were up 2.8% in March, above the central bank's 2% target. However, price growth has slowed substantially since last fall, when the rate of inflation was 3.6%.
Meanwhile, the economy is starting to show signs of weakening. The gross domestic product grew at an annual rate of 1.6% in the first quarter of 2024, which was lower than expectations. While the unemployment sits below 4%, job openings are declining.
Still, the Fed is being patient, preferring to wait until inflation cools a bit more before adding gas to the economy.
Will CD rates rise or fall?
CD yields have climbed dramatically over the past year in response to the Fed raising interest rates. The Fed's decision to pause rate increases will may cause savings yields to grow less quickly, or perhaps peter-out over time.
It’s easy to imagine deposit yields declining if the economy falters, as investors anticipate future rate cuts. But what if the economy continues to grow and averts a recession? In that case, CD rates, chiefly longer-term rates, may start to creep up.
Why do shorter-term CDs offer higher rates than longer-term ones?
Do a little research and you’ll notice something odd: One-year CDs are yielding more than three-year ones. Typically you’d expect that to be the opposite: Banks should have to reward you more for keeping your cash tied up for longer.
That’s not the case now. Even though the Fed is raising short-term rates to moderate inflation, market participants are keeping longer-term rates in check because they think the economy will ultimately slow down.
Frequently asked questions (FAQs)
Certificates of deposit have a few key functions that can help you meet your financial needs. They are a savings product that ties up your cash for a specific number of months and yields a fixed rate of interest, usually higher than what you’ll find on a savings account. Therefore, you can enlist cash you don’t need right away to earn a better yield. (If you end up needing the money, you’ll likely pay a fee to access it.)
CDs, then, can also function as a way to incentivize you to not waste your savings. If you’re worried about your willpower to keep a big chunk of change in your savings account intact, consider using a CD as a means of self-control.
CDs and savings accounts are both savings products, but there is a key difference. CDs typically require you to lock up your cash for a period of time and, in exchange, you receive a higher interest rate than you might find on a savings account. Savings accounts, though, are liquid, which means you can withdraw your cash whenever you need it.
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