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The federal funds rate and CD rates

How the federal funds rate affects finance
CD rates and the federal funds rate

Rates on certificates of deposit follow the federal funds rate nearly exactly. When the Federal Open Market Committee raises or lowers the federal funds rate, CD rates follow.

There has been at least one recent occurrence of the opposite, when CD rates increased before the federal funds rate.

"In August 2003, the (federal) funds rate was 1.25 percent, and the national average for CDs was 1.91 percent. The Fed kept the funds rate flat until June 2004. For 10 months, it was unchanged, yet the market moved interest rates independently, so the average of CDs went up to 2.25 percent, and only after June 2004 did the Fed increase the funds rate," says Dan Geller, executive vice president of Market Rates Insight, a pricing consultant to financial institutions.

Geller says that could happen again this year if businesses begin to borrow as the economy expands. "It's possible because there is a precedent," he says.

To find the sweet spot for CD rates, banks use the overnight rate as their benchmark and turn the dial on CD and savings account rates to fit loan demand. When there is a higher demand for loans, CD rates increase but not too much. For loans to be profitable, banks leave a cushion between the rates paid on deposits and the interest charged for loans, called the net interest spread.


 

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