Watch CD Rates as Inflation Returns

Moving out to longer-term CDs has been a logical solution for depositors frustrated by generally low bank rates. However, with the inflation trend starting to turn, you need to think twice before locking in today's CD rates for the next few years.

Indications are that the US economy is moving from a period of deflation back to an environment of moderate inflation. It this is so, then CD rates will need to adjust to keep up. Until they do, they could leave you earning less than the inflation rate.

Interest Rates on CDs and the Deflation-to-Inflation Crossover

The latest Consumer Price Index (CPI) release, for October 2009, indicates that a new direction in the inflation trend is underway. While October's CPI number was not in itself dramatic, it did represent a somewhat normal pace of inflation--and this is in sharp contrast to the deflationary trend that had prevailed for much of the prior year.

Throughout most of 2009, the year-over-year CPI numbers had been negative, and from May through September they were negative by more than 1%. Negative CPI numbers mean deflation, and this put the low bank rate environment in a different light. Effectively, that period of deflation meant that depositors were adding 1% or more in purchasing power on top of their CD rates, which made those low bank rates a little more palatable.

Things are changing now. The CPI hasn't had a negative month since March. With the release of the October figures, the year-over-year CPI change was -0.2%. Barring a dramatic change in the economy, CPI appears to be headed back to positive territory. So far in 2009, inflation is on pace to end the year at an annual rate of around 2.7%.

From a historical perspective, 2.7% is a moderate level of inflation, but from the standpoint of sub-2% CD rates, even that much inflation would be damaging. It would mean that depositors were losing rather than gaining purchasing power from their savings.

Watching Bank Rates Adjust

When inflation reestablishes itself, you can expect bank rates to adjust. However, this may not happen as quickly as depositors would like. After all, banks are grasping to find profitability where they can, and keeping deposit rates low while market rates rise is an appealing prospect. Also, until the lending business picks up, banks have less incentive to attract deposits. So, not every bank is going to bend over backward to offer deposit rates that keep pace with inflation.

Eventually, though, the laws of supply-and-demand and competition should prevail in adjusting bank rates upward to the new inflation environment. Until then, depositors would be wise to follow two simple rules:

1. Do not lock in bank rates until these changes have played out. The inflation picture is in a state of flux. Until it settles into a new trend, and until bank rates adjust to that trend, avoid longer-term CDs in favor of shorter maturities or savings accounts. Liquidity and flexibility are more valuable right now than eking out that extra interest rate on CDs with multi-year terms.
2. Keep your eye on the banking market. Different banks are going to adjust their rates to changes in inflation at different times. You may find your current bank is slow to adjust. Keep your eye on the banking marketplace at Money-Rates.com so you can find alternatives that will help you stay ahead of inflation.

Source:

 

• US Bureau of Labor Statistics: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet
• US Bureau of Labor Statistics: http://data.bls.gov/PDQ/servlet/SurveyOutputServlet?data_tool=latest_numbers&series_id=CUSR0000SA0&output_view=pct_1mth

 

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