In the article, “I Know Where CD Rates Will Be In 2015! Why doesn’t Nobel Laureate Thomas Sargent”, Learn Bonds makes the following claim:
National short term CD rates (6 month, 1 year, 2 year, 30 months) closely follow the FED funds rate which is controlled by the fed
In this article we will provide the empirical support for that statement. First lets define what we mean by short-term CD rates. We mean CD rates of 30 months or less. If in the chart below we used the interest rate on the 5 year CD instead of the 30 month, the relationship would not appear to be as direct.
The Fed has two main ways in which it controls short-term interest rates:
- By setting a public target for the FED Funds rate
- By selling and buying short-term treasuries. As a result, and as the chart below shows, CD Rates and the FED Funds Rate move in tandem.
The chart below shows that CD rates also move in tandem with short-term treasuries and the FED Funds rate, except when the Fed Funds rate is very high or very low.
Green Line – Fed Funds Rate
Red Line – 2 Year Treasury Rate
Blue Line – 30 Month CD Rate
Why does there appear to be natural levels where CD rates resist the pull of monetary policy? For the 30 month CD, these levels appear to be above 3% and below 1%. Between these levels, the rate very closely tracks the FED Funds rate. While the CD rate will follow the direction of the the other rates above and below these levels, the move in CD rates is much slower and takes longer to occur. There seems to be an absolute floor at the CD rate of 0.26%
Despite, the FED funds rate being around 0.12% since 2009, over three years, both the CD rate and the Treasury rate will not go below this level. I believe there is both a psychological and practical reason for this.
The Psychology of CDs
CDs are consumer products. In other words, they are primarily purchased by non-financial professionals. Just like laundry detergent, consumers have a general feeling about how much they should be earning on a CD. A 30 month CD that earns above 3% or more is “a good rate”. Below 1% is “a bad rate” which might drive a consumer to look for alternative higher paying CD. I think once the yield goes below 0.25%, consumers have the attitude “why bother” as below that level consumers feel the rate might as well be zero.
Most CDs have large penalties for early withdrawals. At very low rates, the perceived opportunity cost for locking up money for a couple years is considered less than the forgone interest. In short at less than a 1 %, some investors start putting more money into savings and checking accounts where there is no penalty for moving money. At a quarter percent, a savings account is considered a better choice for most.
To see a list of high yielding CDs go here.