CD Rates and Inflation: Two Views

Inflation has an impact on all bank rates, but nowhere is it more important than in decisions about certificates of deposits (CDs). This is because the length of the commitment you make to a CD depends on an implicit assumption about inflation.

Bank rates generally will rise and fall over time along with the inflation rate. Sometimes they'll trail inflation and sometimes they'll provide a nice cushion over it, but savings account rates and money market rates have the flexibility to move with inflationary trends at any given time.

Not so with CD rates, of course. With a CD, you are locking into a rate for a specified term. That lock can be a real benefit if inflation falls, but it can leave you stuck with decreased purchasing power if inflation rises in the meantime. A major key to deciding on the length of a CD term is assessing whether you think inflation will rise or fall in the months ahead. Recent evidence has provided mixed signals on this issue.

CD Rates and Inflation: The Optimistic View

According to the Bureau of Labor Statistics, the Consumer Price Index (CPI) was flat in the month of February, meaning that inflation was essentially non-existent for the month. This is a positive for CD rates--obviously, even very low CD rates can beat inflation if inflation is 0%.

February's inflation rate was the lowest in nearly a year, and that raises an important question: was it an aberration, or does it mean inflation is slowing? If you think it's a sign of slowing inflation, then you'd be more inclined to lock into CD rates at current levels. However, looking at the trend of inflation over the past year could lead to a less optimistic conclusion.

CD Rates and Inflation: The Pessimistic View

With a 0% change in inflation for February, the inflation rate for the previous 12 months stood at 2.1%. That's a pretty low inflation rate, but at the same time a year ago, the trailing 12-month inflation rate was even lower, at 0.2%. In other words, over the past year, the annual inflation rate has risen by 1.9%.

Meanwhile, CD rates have gone in very much the other direction. According to figures from the Federal Reserve, 1-month CD rates were at 0.49% in February 2009. This was already an all-time low, but they've since dropped to less than a third of that level, with a rate of 0.16% for February 2010.

Looking at both inflation and CD rates over the past year, you get a picture of two lines moving in opposite directions--and in the wrong directions, as far as CD buyers are concerned. CD rates have been falling while inflation has been rising, and that's a bad combination for putting your money into CDs.

Inflation can be very hard to predict, but the fact that CD rates are so low by any measure--absolute, historical, and inflation-adjusted--may be the clinching argument against locking into a long-term CD at this time. No matter what you decide about CD terms, the one thing you can control is actively shopping for CD rates. This can make a huge difference at a time when you need every edge in rates you can get.

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