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Inflation to push CD rates?

By Claes Bell, CFA ·
Wednesday, March 2, 2011
Posted: 12 pm ET

According to a report by the Dallas Fed (via Mark Thoma), core inflation crept upward in January. If that trend continues, we may see the Federal Reserve raise the federal funds rate, which would in turn cause banks to offer higher CD rates. Here's Dallas Fed senior economist Jim Dolmas:

Core PCE (personal consumption expenditures) posted a 1.5 percent annualized gain in January, up from a 0.4 percent rate in December. January’s 1.5 percent is the fastest one-month rate of increase in the core since March of last year, when the monthly core readings were, by and large, drifting downward.

Core CPE differs from headline CPE, because it leaves out volatile food and oil components, which can quickly skew inflation numbers. What was behind the Core CPE rise? Here's Dolmas:

For the past several months, core goods prices have fallen at a rather healthy clip, relative to recent historical patterns, declining at an average annualized rate of about 1.6 percent since last September…

… January's core goods data break with that pattern—and perhaps illustrate the value of trimming in the process—coming in at an annualized rate of increase of 3.3 percent, the biggest one-month gain since a 3.6 percent rate in September 2009. Apparel prices were the chief culprit: The price index for women's and girls' clothing increased at a nearly 20 percent annualized rate and alone contributed about 0.3 annualized percentage points to January's core rate.

If core inflation continues to pick up, don't be surprised if the Fed moves to raise interest rates earlier than previously thought. If that happens, CD rates could rise sharply in 2011, putting those with short CD ladders in the best position to maximize overall return. After all, you don't want to be stuck in a 5-year CD yielding 2 percent if CD rates rise precipitously. The last think you want to see is one-year CD rates rising until they're higher than the rates on the long-term CDs you're holding.

In that case, too big a share of your money stuck in long-haul CDs would mean your yields in 2012 and beyond would not only be well below what they should be, but that they'd likely be swallowed up by rising inflation.

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