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CD rates: Now behind inflation

September 26, 2011

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

The relationship between CD rates and inflation is certainly unusual right now, but is it uncharted territory? A look at the history of this relationship can help put today's conditions in perspective, and help you make decisions about your next CD.

The basic deal is this: interest rates on CDs aren't supposed to give you spectacular returns, but they are supposed to beat inflation. That's not always the case, though--for example, today's CD rates are clearly trailing inflation. While this is unusual, it has happened before, and looking at that history can help answer two questions:

  • How bad can it get?
  • How long will it last?

CD rates and the inflation gap

To start with the question of how bad it can get, historically even one-month CD rates have beaten inflation on average, but they have gone through several periods where they have fallen behind.

To put this in perspective, historically one-month CD rates have beaten the prevailing 12-month inflation rate by an average of 1.68 percent. As of April, one-month CD rates trailed the prevailing inflation rate by 3.02 percent. That means that the relationship between one-month CD rates and inflation is out of whack by 4.7 percent.

So can it get any worse than this? Well, just because something hasn't happened before doesn't mean that it won't happen in the future. Still, history gives us some sense of what's possible. That history tells us that yes, the relationship between CD rates and inflation can get worse than this, but it is rare.

Looking at CD rate history from the Federal Reserve that goes back to 1965, and at inflation history from the Bureau of Labor Statistics, one would find that since 1965 there have been only 13 months (an appropriately unlucky number) before this past April when one-month CD rates have trailed inflation by 3 percent or more. That amounts to just 2.4 percent of the time. The worst inflation gap was reached in June 1980, when one-month CD rates fell behind the prevailing inflation rate by 5.87 percent.

So it's very rare for conditions to be this bad, but it could get a couple of percentage points worse.

How long will it last?

Turning to the question of how long interest rates on CDs can trail inflation, the same history tells us that there have been 16 periods when one-month CD rates have been lower than inflation. These periods have averaged just over eight months in length, and only two of them have been longer than the current streak of 18 months.

This is the good news. While history tells us that things could get worse, it also suggests that these conditions won't last for long.

In the meantime, recognize that locking into CD rates under these conditions means not only accepting unusually low rates, but also taking on the clear and present danger of inflation risk. That might just influence you to make your next CD a little shorter, until conditions for CD rates and inflation get a little better.

 

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