CD Rates Benefit from Deflation, But for How Long?CD Rates Benefit from Deflation, But for How Long?
October 07, 2009
Will CD Yields Be Erased by Rising Inflation?
One of the factors mitigating the across-the-board low bank rates available to depositors this year has been the deflationary economic environment. However, a look inside the latest Consumer Price Index (CPI) numbers suggest this may be changing. Therefore, before you lock into a certificate of deposit (CD), you need to consider whether inflation will soon catch up to CD rates.
CD Rates and Deflation
Deflation means that prices overall are falling; it is the opposite of the more normal condition of rising prices, known as inflation. The CPI is the most commonly used measure of US inflation, and when the change in that index over a period of time is negative rather than positive, it indicates an overall economy experiencing deflation rather than inflation. Deflation is so rare that most people have little or no experience with it--2009 has seen the most pronounced example of year-over-year deflation since the beginning of 1950.
What does all this mean for CD rates? Falling prices are a bonus for depositors, because they mean that, in addition to earning interest, you are also gaining purchasing power. Another way to think of it is that when there is deflation, it means that bank rates are really higher than they seem. If you have a 1% interest rate on a CD and there is 1% deflation, you are earning roughly 2% after inflation. That's just as good as earning a 6% CD rate when inflation is around 4%. The math isn't quite as simple as just subtracting the inflation rate from the rate of return, but for short-term periods with relatively low investment amounts, that is a fair approximation.
Recent Inflation Trends
During the summer months of 2009, deflation did reach the 1% mark on a year-over-year basis. This meant that over the past year, CD holders have gotten the bonus described above. CD rates may have seemed low, but they actually worked out to be better than they appeared. Interest rates on CDs, of course, remain low, but can depositors continue to count on this boost from deflation?
If you look at the past year's CPI numbers, you'll see why CD depositors may be concerned. The good news (at least from a depositor's standpoint) was that for the year ending August 2009, the CPI had declined by 1.4%. That means that 1-year CDs, which are yielding about 1.6% on average, would actually represent a healthy 3% or so overall return after inflation if that annual deflation trend were to continue.
A breakdown by the monthly numbers, however, suggest that all the deflation in the year-over-year number occurred in late 2008. So far in 2009, the CPI has gained 1.8%. At that rate, that monthly figure translates into a 2.7% annual rate of inflation--not extraordinarily high, but a significant problem if you are locked into a CD rate between 1% and 2%.
Options for Depositors
Given this environment, depositors could stick with savings accounts, to avoid locking into a CD rate. Or, they could go the other way and choose a longer-term CD. Locking in to a 5-year CD, for example, would earn you a higher cushion over inflation, but only as long as inflation comes back moderately and does not get out of hand.
Whichever way you choose to go, remember that you can use money-rates.com to find the best account option available to you.
Source:
Bureau of Labor Statistics: Consumer Price Index Monthly Data • http://data.bls.gov/PDQ/servlet/SurveyOutputServlet?data_tool=latest_numbers&series_id=CUSR0000SA0&output_view=pct_1mth
