Slowing inflation boosts real CD rates
August 19, 2011
A couple months ago, CD rates did not stand a chance against a rising tide of inflation. Things have changed dramatically since then, and this might impact decisions you make about the CD rates you look for and about the length of the CDs you choose.
No, CD rates have not suddenly risen. However, the momentum behind inflation seems to have faded quite suddenly.
CD rates and inflation: then and now
Long-term CD rates are actually a little lower now than they were a couple months ago. At the end of May 2011, interest rates on CDs ranged from 0.12 percent for 1-month CDs to 1.63 percent for 5-year CDs, according to the Federal Deposit Insurance Corporation (FDIC). By early August, this range had narrowed, from 0.12 percent to 1.55 percent.
A drop of 0.08 percent in long-term CD rates isn't particularly significant. What is significant is the shift in the inflation environment. At the end of May, the year-over-year inflation rate had risen to 3.6 percent. Monthly inflation readings for the first five months of the year averaged 0.4 percent, a pace that would push inflation close to 5 percent if it continued for an entire year.
Then, inflation reversed course in June, with the Consumer Price Index declining by 0.2 percentage points. The year-over-year rate still stood at 3.6 percent, but that was because of what had happened in prior months. If price declines, or even milder increases, take over in the months ahead, that year-over-year rate will start to work itself down.
Is there reason to believe that inflation will weaken in the months ahead? Oil prices are a very strong reason for believing this could happen. Rising oil prices had created much of the pressure behind inflation in the early part of 2011. However, oil prices peaked at the end of April and have been declining since, a descent which steepened as financial markets panicked in early August. These moderating oil prices bode very well for lower inflation.
A stronger case for longer-term CDs
A couple months ago, it would have been hard to make a case for long-term CDs. Even though long-term CD rates were considerably higher than short-term rates, they still were less than half the prevailing rate of inflation. Worse, that inflation rate was on the rise, making it a particularly dangerous time to lock into long-term CD rates.
Long-term CD rates still aren't beating the year-over-year inflation rate, but two important things have changed since the end of May:
- Inflation seems to be falling rather than rising. This trend would mean that long-term CDs would become more valuable to depositors over time, rather than losing more and more ground to inflation.
- Economic prospects have dimmed. The economy seems to have run out of steam, and with the budget deal having committed the U.S. to new austerity measures, there is little the government can do to stave off a new recession. This means that the day interest rates start to rise seems farther off than ever--which reduces the opportunity risk of locking into a long-term CD today.
As gratifying as it would be to see CD rates rise, the real value of those rates has to take inflation into account. If inflation starts to decline, as it seems on a trend to do, that's just as valuable to depositors as a rise in CD rates.
