How the Fed sways CD rates

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Ben Bernanke, the former chairman of the Federal Reserve, recently wrote that the rates set by the central bank follow the economy. How does that lead to low rates on certificates of deposit?

CD rates flow from the Fed

“While the Fed doesn’t set market interest rates such as Treasury bond rates and mortgage rates, it influences them through two key interest rates — the Fed discount rate and the federal funds rate,” says Robert Johnson, CFA, president of The American College of Financial Services in Bryn Mawr, Pennsylvania, and co-author of the book “Invest with the Fed.”

“Changes in the discount rate are considered a reliable signal of the Fed’s long-term policy intentions, or stance. Changes in the target fed funds rate are considered a shorter-term gauge of the stringency of Fed policy,” he says.

When the target federal funds rate increases, tighter monetary policy leads to higher rates for borrowing and economic growth is squeezed. As the fed funds rate goes up, so do CD rates.

“CD rates are highly correlated to Fed policy actions, following the fed funds rate extremely closely. Banks peg CD rates off of the federal funds rate,” Johnson says.

But not all investments go up with interest rates.

“Stock markets loath Fed rate increases. And, our research shows that Fed rate increases are generally followed by poor equity market performance. CD investors will see higher rates offered by financial institutions on CDs,” says Johnson.

The Fed is expected to increase the federal funds rate this year but there’s no telling if or when that will really happen. In the meantime, you may need someplace else to keep savings besides CDs.

Buy a CD now or wait?

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Senior investing reporter Sheyna Steiner is a co-author of “Future Millionaires’ Guidebook,” an e-book written by Bankrate editors and reporters. It’s available at all the major e-book retailers.