How Will CD Rates Respond to Hints of Inflation?

Like all bank rates, CD rates have been pretty low this year. Just about any way you slice it--in absolute or historical terms--CD rates have been low enough to make depositors think twice before committing their money. However, there has been one silver lining. The deflationary environment the US has experienced over much of the past year has made those CD rates, and bank rates in general, worth more than meets the eye in terms of purchasing power.

Unfortunately, this may be in the process of changing. For depositors, the prospect of returning inflation means another reason to shy away from locking up money for too long at current CD rates.

Glimpses of Inflation

It would be unfair to say that inflation has re-established itself, but there have certainly been glimpses of it. The Consumer Price Index (CPI) increase for September was a moderate 0.2%, and for the 12 months ending September 30, the CPI remained negative at -1.3%. However, the last negative monthly reading for the CPI was in March, and four of the last six months have shown positive readings (with the other two being flat). Even a moderate return of inflation would require an adjustment by bank rates to stay ahead.

More recently, rises in oil and gold prices have been symptomatic of weakness in the US dollar. Given the huge amount of goods the US imports, a weakening dollar could bring further inflation pressures.

In short, the CPI numbers may still look benign on the surface, but recent months have given glimpses of returning inflation, and the fundamentals are lining up for more of the same.

Delayed Response from CD Rates

A bank rate below the rate of inflation would mean losing purchasing power--not a deal that would attract depositors in droves. So, with inflation rallying, bank rates must be on the rise as well, right?

Not so fast. Thus far, CD rates haven't really budged in response to recent inflationary signals. This could be a sign of understandable caution on the part of banks. CDs represent a commitment to pay a stated interest rate for months or years. With the profitability of many institutions still somewhat fragile, banks are not going to make that commitment at higher rates until they see more than glimpses of inflation. It may take a sustained inflationary trend to get CD rates moving.

Evaluating CD Rates Under Today's Circumstances

So what can you do about CD rates in this situation? If you think inflation may be coming back but CD rates have yet to respond, how do you evaluate CDs? There are two things you should do in this situation:

• Keep commitments short. If banks aren't ready to make commitments at higher rates, then you should avoid long-term commitments at low rates. Keep your CD terms short, and consider savings or money market accounts as alternatives. You may still use longer-term CDs as part of a laddered or barbelled strategy, but overall your weighting should be toward the short term.
• Shop diligently. Be sure to shop around for CD rates before you make any kind of commitment. Differences in CD rates from one bank to another are surprisingly large, and the way things are looking, could make the difference between beating inflation or not.

Source:

Energy Information Administration: http://tonto.eia.doe.gov/dnav/pet/pet_pri_spt_s1_d.htm

Federal Reserve: http://www.federalreserve.gov/releases/h15/data/Weekly_Friday_/H15_CD_M6.txt

US Bureau of Labor Statistics • http://www.bls.gov/news.release/cpi.nr0.htm

Yahoo Finance: http://finance.yahoo.com/echarts?s=%5ETNX#symbol=%5ETNX;range=6m

OnlyGold.com: http://www.onlygold.com/TutorialPages/PricesY2KFS.asp