With the economy apparently emerging from its long recession, could this also be a turning point for bank rates? A comparison of CD rates following past recessions gives a mixed answer, though the message is decidedly more optimistic when inflation is taken into consideration.
CD Rates in Theory and Reality
In theory, bank rates should rise as the economy recovers. As spending and investment increase, there is more demand for capital, and the price of that capital should rise. Interest rates are one expression of the price of capital, so bank rates should rise once a recession ends.
CD rate information is available for a time spanning the six recessions prior to the most recent one, so it is possible to see how this theory checks out against reality. On the surface, the results would seem consistent with theory, as 3-month CD rates rose by an average of 0.77% in the 12-month periods following the ends of the last six recessions. However, this positive result is skewed by one spectacular rise in CD rates following the 1980 recession. CD rates rose following the ends of only two of the past six recessions--so an economic recovery is hardly a reliable harbinger of higher bank rates.
Factoring Inflation into CD Rate Changes
The biggest "x-factor" that disrupts the relationship between bank rates and economic recoveries is inflation. Indeed, the period for which historical CD rate information is available, from the mid-1960s to the present, was a period marked by dramatic changes in the US inflation rate. Over this period, inflation went from very low levels to record highs and then back to extreme lows. In fact, four of the last six recessions were accompanied (and probably exacerbated) by flare-ups in inflation.
Since bank rates are somewhat responsive to inflation conditions, an erratic inflation environment can throw off the expected relationship between interest rates on CDs and economic cycles. You can somewhat neutralize the inflation effect by looking at changes in real CD rates--CD rates over and above the rate of inflation. When the trailing 12-month inflation rate is subtracted from prevailing interest rates on CDs, the relationship between economic cycles and bank rates behaves more as expected.
After taking out the effect of inflation rates from historical CD rates, the response to economic recoveries is more robust. These inflation-adjusted CD rates rose by an average of 2.67% in the year following the last six recessions, and CD rates rose in four of those six cases.
Since bank depositors should be most concerned with what they earn over and above inflation, the fact that CD rates generally seem to rise in inflation-adjusted terms following recessions should be taken as an optimistic sign for the upcoming months.
Considering Current Conditions
Naturally, there are more factors affecting bank rates than the economic cycle. We've seen that inflation can be a factor, and government policy in response to a recession can also affect interest rates. As things stand now, we are coming off a period of extremely low inflation, and throughout this year the government has taken extraordinary measures to drive interest rates down.
Looking forward, it's unlikely that those same factors will counteract the effects of the economic cycle. As government policies that have been holding down rates are unwound, these policies--and the fundamentals of the recovering economy--point to higher bank rates in 2010.
Business Cycle Expansions and Contractions • National Bureau of Economic Analysis: http://www.nber.org/cycles/cyclesmain.html