Here’s Why a 4% Inflation Rate Is Good (and Bad) News for CDs

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The Fed’s interest rate hikes have been good for CD rates. Learn why a falling inflation rate could change that. 

For decades, certificates of deposit (CDs) were nothing to gush over — just a safe place to park some cash without enduring the volatility of stock markets. And while the security aspect of CDs hasn’t changed, their APYs in 2023 are no longer laughable.

Right now, many CD rates are between 4.25% and 5.25%. Much of that high interest has to do with the Federal Reserve’s relentless campaign against high inflation, which has pushed the federal funds rate to a range of 5% to 5.25%. Though the funds rate doesn’t decide CD rates directly, banks tend to pay more to depositors when the funds rate is higher.

Inflation remains a problem for the Fed, but recent CPI data has been encouraging. The most recent report from June 13 showed that the year-over-year increase in prices was 4% in May, down from 4.9% in April. Though the Fed wants to bring the inflation rate to 2%, May’s CPI reading indicates we’re getting there, however slowly.

But for prospective CD holders, here’s a question to ask — if inflation continues to fall, what does that mean for CDs? In general, I think it’s good news for current and recent CD holders, but for those who are waiting for CD rates to increase substantially, I think there could be disappointment on the horizon.

CD rates outpace inflation

With the federal funds rate between 5% and 5.25%, the majority of CD rates have surpassed inflation.

Take, for example, Bread Savings CDs, which have some of the highest APYs on certificates of deposit. As of June 27, 1-year Bread CDs, which have a minimum deposit of $1,500, are boasting APYs of 5.25%. Even its 5-year CD is above inflation at 4.25%. That’s significant, because long-term CD rates currently have lower rates than short-term ones, simply because banks are expecting the Fed to lower its federal funds rate sometime in the future. Even so, long-term Bread CDs are outpacing May’s CPI reading of 4%.

One caveat to keep in mind: Your CD’s actual APY will depend on your federal tax rate, as interest in a CD is taxed as ordinary income in the year it’s earned, unless it’s held within a tax-advantaged account such as an IRA. Even so, many of the best CD rates could still earn above the rate of inflation even after taxes.

If the Fed successfully corrals inflation to its targeted goal of 2%, then a long-term CD with an APY of 4.25% could be a decent hedge against inflation at that time. That would make current rates on 2- to 5-year CDs something to get excited about, especially if you have savings you won’t need to use within that period.

The party could be coming to an end

Let’s be clear: CD rates won’t stay this high forever. While the Fed has indicated it may hike the funds rate again before the end of this campaign, its end goal is to eventually reverse rate hikes to a range more conducive to economic growth. When it does reverse course, banks will likely match the Fed’s actions and lower APYs on its CDs.

But not even the Fed knows when it will cut rates. Personally, I thought we’d see at least one rate cut in 2023, but now I’m second-guessing myself. Jerome Powell said the Fed still has a “long way to go” to get inflation down to 2% and even hinted it will hike rates again before the end of the year.

Those investors interested in CDs should keep an eye on the June 2023 CPI report, which is scheduled to be released on July 12. Ultimately, we know the CD party is coming to an end. Whether it’s a weekend party, however, or a Friday night, the June 2023 CPI report might give us some indication.

If you know a CD is the right savings vehicle for you, I would take advantage of today’s CDs regardless. A short-term CD, such as a 3- or 6-month term, could be a viable solution, as it minimizes how long your money is locked up but still captures a rate that will be higher than inflation. Since we don’t know what the Fed’s decision will be, alternatively, you could look into a high-yield savings account, whose APY doesn’t have a fixed term like a CD but could still help you earn above inflation while you await the Fed’s next steps.

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