If you’re under 30 years old, this is the best time in your adult life to buy a certificate of deposit (CD).
That’s not hyperbole. It’s a data-driven fact. After years of languishing near zero, CD rates spiked in 2022 and are now higher than they’ve been since at least 2008, right before the economy crashed into the Great Recession.
But before you rush out to your local bank or credit union to buy a CD — or, more likely, find an online bank with even better CD rates — you’ll want to read our take on where CD rates go from here. They might not be done climbing, which means it could pay to wait just a little while longer.
CD Rates Have Been Low, But Increasing With Interest Rates
The 3-month CD, a benchmark that’s lower than longer-term CDs but more responsive to changes in prevailing interest rates, has been near zero since the Great Recession.
That means that buying a 3-month CD was not much different than taking your cash out of the bank and putting it in the mattress. The average rate of return fluctuated between 0.05% and 0.30% for most of the period between 2009 and 2021, lower than the inflation rate. So money held in short-term CDs slowly lost value in real terms.
That started to change in early 2022 as the Federal Reserve began a belated rate hiking cycle that continued into 2023.
Short-term CD rates were slower to rise and didn’t increase as much, but medium-term CDs climbed quickly as the Fed began hiking the federal funds rate. Today, many online banks pay 4.50% APY or better on 12- and 18-month CDs, in line with the current federal funds rate of about 4.50%.
Longer-term CD rates are more variable due to expectations that prevailing interest rates will decline later in 2023 and into 2024, but 5-year CDs still yield between 4% and 5% APY at many banks. As has been the case for decades, credit unions and digital banks tend to have higher CD rates than bigger brick-and-mortar banks, which don’t face as much competitive pressure to reward ordinary savers.
CD Rates Follow Interest Rates Very Closely
The historical correlation between CD rates and the federal funds rate is impressive. From 1967 until 2015, the 3-month CD rate closely tracked the federal funds rate on a 6- to 12-month lag.
The federal funds rate directly influences the rates banks charge one another for short-term interbank loans, which in turn determine the interest rates on loans to consumers and businesses.
Rates on CDs and other types of deposit accounts (known as “yields” when it’s the customer getting paid) are always lower than rates on mortgages and other types of bank loans because banks can’t make money if they pay their depositors more interest than they receive from their borrowers. Banks use a straightforward formula to set loan rates — basically, they add a fixed percentage to the benchmark the rate is based on. So if the fixed percentage for a 30-year mortgage loan is 3.25% and the benchmark rate is 4%, the borrower’s rate is 7.25%.
The close relationship between short-term CDs and the federal funds rate broke down around 2015. Around this time, the Fed began a slow but steady hiking cycle that saw the federal funds rate top 2% by 2018. Yet 3-month CD rates barely budged. Longer-term CD rates didn’t fare much better.
One reason (though not the only one) is that other benchmark rates, particularly 2- and 10-year U.S. Treasury bond rates, remained low. This suggested that the broader market — of which banks themselves are a key part — expected inflation to stay in check for the foreseeable future. And indeed, the annual inflation rate stayed more or less in line with the Fed’s long-term target of 2%. Mortgage and other consumer loan rates hovered between 3.5% and 5%, limiting banks’ flexibility to raise deposit account yields (not that they wanted to anyway).
During the first months of the COVID-19 pandemic, after the Fed slashed the federal funds rate to near zero, rates on all CDs cratered, restoring the tight correlation. Though it’s still a bit too early to tell, that correlation appears to have held during the Fed’s current rate-hiking cycle. 3-month CD rates are higher than they’ve been in more than 10 years, and they’re still rising even as the Fed slows its hiking pace.
CD rates are high right now (by recent historical standards) because the federal funds rate is high right now (by recent historical standards). And the federal funds rate is high right now because inflation is high right now (by recent historical standards).
The federal funds rate is the Federal Reserve’s primary weapon in the fight against inflation. As the chart below shows, the federal funds rate correlates closely with the consumer inflation rate, though not as closely as with 3-month CD rates. This correlation generally occurs on a lag, with the federal funds rate following the inflation rate up and down.
The Fed’s current hiking cycle began in March 2022, too recently for the chart to capture. But you can already see the orange inflation line shooting upward off the right side. That’s the sharp, painful price spike we’ve all been dealing with since mid-2021 or so.
The blue federal funds rate line will follow. As the inflation rate falls back toward 5% and the federal funds rate continues to climb, the two lines will intersect sometime in 2023.
The Markets Expect the Fed to Raise Rates Again…
The Fed is closer to the end of the current rate-hiking cycle than the beginning, but economists and market participants widely expect at least one more increase. But several heads of regional Federal Reserve banks argued for additional rate hikes that would push the federal funds rate above 5%, higher than the market’s “terminal rate” consensus (where observers think the rate will top out this cycle).
Due to the close correlation between the federal funds rate and CD rates, a higher terminal rate means higher CD rates in the short to medium term. And because the Fed wants to be sure that inflation is well under control before it starts to lower the federal funds rate again, it could be months — perhaps all the way into 2024 — before we see a meaningful change in the U.S. interest rate regime.
The biggest threat to this outlook is the health of the broader U.S. economy. So far, despite big-company layoffs in the headlines almost every day, unemployment remains low and consumer and business spending relatively strong. Cautious optimism is building for the Fed to engineer a “soft landing,” where inflation cools without a proper recession or significant increase in the unemployment rate.
But many in the business community aren’t so sure, and as we saw in early 2020, economic conditions can turn on a dime. Should the outlook darken or cracks appear in credit markets — threatening a rerun of the late-2000s financial crisis — then the Fed might be forced to lower rates earlier than it would like. CD rates would surely follow, retracing gains made in 2022 and early 2023.
…Which Means That CD Rates Will Likely Continue Rising
We expect CD rates to continue rising during the first half of 2023, albeit at a slower pace than in 2022. By June 2023, the average 3-month CD rate could be in the 2% range, while rates for 12- and 18-month CDs could top 5%.
Longer-term CD rates are more difficult to predict in the current environment because longer-term inflation expectations remain in check. According to the New York Fed’s closely watched Inflation Expectations Index — which surveys ordinary heads of household but which is widely seen as a proxy for how banks think about longer-term rates — consumers surveyed in December 2022 expected annualized inflation at:
- 5% in December 2023
- 3% in December 2025
- 2.4% in December 2027
Banks respect consumers enough not to offer CDs paying too far below the expected average inflation rate over the full term, as long as the federal funds rate and prevailing loan rates allow for it. That’s why 12- and 18-month CDs already pay close to 5% in early 2023, and while they’ll probably top that rate as the year wears on. But with 5-year inflation expectations well below 3%, banks don’t (yet) feel any pressure to boost 5-year CD rates much beyond the current federal funds rate.
This could change if inflation proves stickier than expected. If consumer price increases settle at a 5% annual rate in 2024, 5-year CD rates will assuredly go higher.
That’s not the base case right now, which is why those medium-term 12- to 18-month CDs are so enticing in 2023. With the Fed’s hiking cycle likely to end in Q2 2023 and CD rates tending to lag the federal funds rate by a few months, the sweet spot for medium-term CD purchases could come in late Q2 and early Q3.
Final Word
Everything is relative. During the notorious Volcker Shock of the late 1970s and early 1980s, 3-month CD rates remained above 10% for nearly 6 years, topping out at a now-inconceivable 17% in 1981. Despite aggressive Fed rate hikes and rampant inflation, the average 3-month CD rate today is something like 2%.
I can’t even imagine the sort of economic calamity that would push 3-month CD rates back above 15%, and I frankly don’t want to. The good news is that it’s not a realistic scenario.
The best CD fans can hope for is that inflation proves a bit stickier than expected over the next few years, but not so sticky or elevated that the broader economy tips into a prolonged recession. Higher baseline inflation would set a floor under the federal funds rate, preventing a march back toward the 0% level that held from 2010 into 2015 and again in 2020 and 2021. This, in turn, would keep CD rates high enough to produce what feels like a decent return — even if they’re largely neutralized by inflation.
Brian Martucci
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