While I like to think of myself as a micro-economic genius, I’m somewhat of a macro-economic ignoramus. With that in mind, what changes would have to happen in the World or US economy in order for CD and bank savings rates to rise to at least 4-5%, or more? Would it be driven by inflation, or debt reduction, or something else? I know it’s related in some way to the Federal Reserve lending rate, but there isn’t a direct tie, yes?
I suppose what I’m trying to see is how likely we’ll ever see bank accounts and CDs which pay rates like they did just a few years ago.
Follow the Australian economic model.
Cash rates as set by the Australian Reserve Bank are now 4.5%.
They were increased by 25 basis points on May 5th, which is the sixth rise in the past seven months.
If you think rates at that level are desirable, then
Produce things the world wants to buy.
Import the goods you don’t have a comparitive advantage.
Operate low barriers to movement of goods and capital.
Maintain relatively low level of domestic savings.
Have preference for borrowing to fund non-productive purposes i.e. residential property.
Have a consequent need to draw on external capital for business and infastructure.
I’m certainly not an expert in CD’s, but manage significant corporate pension and retirement assets. Just thinking through this logically, CD rates are based on supply and demand. Banks are competing against each other for capital (i.e. your money). This is why you can find varying CD rates if you look across multiple banks. So there is no direct link to inflation or anything else.
However…
Investing with a bank is riskier than investing with the US government, the least risky investment in the world (for now). Thus, you would never give a bank your money if it is paying you less interest than the US government (aka the yield on T-bills). The US government can print money, so you will always get your money back. The US government rate is the minimum rate that a bank can give you. Of course, short term US government borrowing rates are controlled by the Federal Reserve bank (The Fed). This is where the indirect link to inflation comes in. If the Fed believes that inflation is probable, it may increase the short term rate of government borrowing. By increasing this rate, it essentially slows down the flow of funds reducing the potential for inflation. Of course, inflation fears are usually due to the economy heating up ~a good economy. So the real link to inflation is the Fed’s forecast of inflation, and not the actual rate of inflation.
By the way, another potential source of inflation is a high debt level of a government. Instead of paying back its debt, a government can simply inflate its way out of debt. It can just print more money (not necessarily literally) and pay back its debt with reduced-value money. Of course, this doesn’t make its borrowers very happy. If the US did this, and there is such a fear, it might not remain the least-risky investment in the world.
So the factors that determine CD rates are the risk-free rate (US government borrowing rate) and the supply/demand for capital (how much money you have versus how much the banks need your money).
It mainly has to do with how the Fed wants to tighten or loosen monetary policy as this will change T-bond (or notes) rates and these products compete with T-bonds for capital.
Monetary policy can go 1 of 2 ways - contratcionary or expansionary - depending on whether you want to fight unemployment (lower rates) or fight inflation (raise rates).
The central bank can affect interest rates by buying or selling government debt (T bonds/notes). By buying up the debt it injects cash into the financial system, reducing interest rates and can raise rates by selling the debt (when banks buy it, cash is removed from the economy, which reduces money supply, making current cash more useful, allowing higher interest rates).
So, when the fed ‘sets rates’ what it is really doing is deciding where it wants the fed fund overnight rate to be, and then it executes repos or reverse repos (or straight purchases/sales) to cause the monetary supply to expand or contract to cause the interest rate to move to the desired level. In theory, you can change the monetary supply and the consequent interest rate by changing the reserve requirements of banks (which is what determines how much cash they can loan based on their deposits/reserves) but this is rarely done as it is too brutish a tactic for interest rates and affects too many other things. the open market operations are really elegant.
Anyway, the whole supply and demand for cash is what determines interest rates ultimately and that’s what drives the bank and cd rates.
Now, the reason the fed will do these things can be simplified - when the economy is crappy, you expand the money supply to stimulate capital investment and help keep unemployment down - when the economy is in full tilt, you reduce the monetary supply to raise rates and keep inflation from taking off.
When you have stagflation, you pray (actually you look to shock the curve… but really staying out of stagflation requires good consumer confidence in the fiscal responsibility of the central bank).
OK…so that’s why one can still get 3% CDs if one goes out 5 years, because the 10-year T-Bill is 3.5-3.8% or so yield now, right?
So generally speaking, which likely is the bigger effect: higher demand for business and private loans in an improved economy, or higher rates on the debt servicing of the Federal Government?
Well, the Central Bank decides what it wants the rate to be, and it uses its own ability to buy and sell US gov’t debt instruments to change the supply of capital in such a way as to force interest rates to reach the desired rate.
The demand for capital for private loans would cause interest to rise on its own, and if this were happening in an up economy and the fed wanted interests rates to increase (contractionary policy) then it would just mean that it would have to do less selling to force the supply demand relationship to come to a point.
In theory, the fed could want rates to go from 3% to 4% over the next 3 months, but consumer demand for loans could be so high that the Fed has to purchase government debt during that time period (something that they would usually do to lower rates) - this is extremely unlikely, but it illustrates the point - which is that the Fed is just altering the relationship of supply and demand so that the desired rate is achieved and other factors really just affect what it is that the Fed needs to do to accomplish their goal.
CDs: What sort of maturity did you have in mind? A 3 month CD will usually pay less than a 5 year CD.
Let’s assume we’re talking about a savings account that pays a competitive rate. (Go to bankrate.com if you want a national comparison). A key rate that it is based on is the federal funds rate, or the rate that banks loan each other short term funds. The Federal Reserve (via “Open Market Operations”-- don’t ask) can essentially set that at any point it likes (+/- .1% say).
The Fed funds rate is at a near-record low 0.25%. It will stay there until the Fed believes that the economy is recovered sufficiently to raise rates. Last time they went into tightening mode, they raised rates at about 1/4 of a percentage point every 6 weeks or so.