Is the Fed Hinting at Higher Savings Account Rates to Come?
February 22, 2010
| MoneyRates.com Senior Financial Analyst, CFA
In January 2010, the Federal Reserve joined other banking regulators in warning banks not to get too complacent about their current profit models. Was this a hint that we might expect higher bank rates in the near future?
At the heart of this discussion is the spread between short-term and long-term interest rates. The relationship between different maturity terms of debt and interest rates is generally referred to as the yield curve. Right now, banks are making a healthy profit by exploiting interest rate differences along the yield curve--at the expense of depositors earning low bank rates. The Fed's warning is a reminder that this can't continue indefinitely.
Savings Account Rates and the Short End of the Yield Curve
As much as the press talks about the Federal Reserve setting interest rates, under most circumstances its control over interest rates is quite limited. The Federal Reserve sets the rate for very short-term borrowing by banks. This influences short-term interest rates, but long-term rates are set by free trading on the bond market. One way to think of the yield curve is like a kite on a string. The Fed holds one end of the string, but at the other end the kite will rise and fall as conditions change.
Most bank rates are considered short-term deposits and thus tend to resemble rates at the short end of the yield curve. Federal Reserve policy to stimulate the economy and assist the banking sector has resulted in very low short-term interest rates. Meanwhile, though, rates at the long end of the yield curve--representing returns for longer-term debt--has risen considerably, as the economy has improved and inflation has re-emerged.
This pattern of relatively high long-term rates and low short-term rates creates what is referred to as a "steep" yield curve, and it has been a golden opportunity for banks. They can pay depositors next to nothing in the form of savings account rates and other bank rates, and then invest that money at much higher yields in longer-term income securities. Ordinarily, banks would be using more of this capital for lending. But with lending demand low and banks still cautious about making loans, "playing the curve" represents a safer way to profit from bank deposits.
How the Fed and Market Forces Affect Savings Account Rates
The Federal Reserve is warning banks not to get too used to this profit model, because it is based on short-term rates that the Fed has kept artificially low. This won't be the case forever, and the Fed is clearly trying to prepare the markets for the day when it will raise short-term rates, though American Banker reports that many leading bank executives aren't publicly worried.
When the Fed raises rates, will savings account rates and other bank rates automatically follow? No--the Fed does not dictate what rates banks have to pay depositors. However, market forces have a strong influence over bank policies. Already, higher rates further out on the yield curve must be tempting some depositors to consider pulling money out of bank accounts and investing in longer-term bonds. However, longer-term bonds are subject to considerable price fluctuations, which is enough to keep most conservative money out of the bond markets and safe in deposit accounts.
Once the Fed raises short-term rates, though, shorter-term bonds will start to represent attractive yield alternatives without the extreme price fluctuations of longer-term bonds. This would be enough to tempt more money out of deposit accounts--unless bank rates rise to stay competitive. The Fed seems to be hinting that this scenario may play out before too long.
