bank rates

Liftoff! Fed Begins Pushing Rates Up

America has finally started down the road toward higher interest rates for savers.

After holding short-term yields at record lows for seven years – a historic length of time – the Federal Reserve changed course Wednesday and began pushing rates higher.

The initial step was a small one, an increase of just a quarter of a point in the federal funds rate.

That’s what commercial banks pay to borrow money from each other through the Fed. It’s the financial lever the nation’s bank for banks uses to control interest rates throughout the economy.

But that modest increase still reverses years of monetary policy that meant Americans could earn no more than a pittance on the savings they entrusted to banks.

The average return on everything from certificates of deposit to savings and money market accounts has been well below 1% since December 2008, when the federal funds rate essentially hit zero.

Today, that savings-crushing era came to an end.

“This action marks the end of an extraordinary 7-year period during which the federal funds rate was held near zero to support the recovery of the economy from the worst financial crisis and recession since the Great Depression,” Janet Yellen, chairman of the Federal Reserve, told a press conference in Washington.

“With the economy performing well, and expected to continue to do so,” she said, “the committee judged that a modest increase in the federal funds rate target is now appropriate.”

The Fed has repeatedly cautioned that it will proceed deliberately after it begins raising rates, a position it reiterated today.

During periods in the past when it was raising rates, the Fed has often proceeded with quarter-point increases at each of the eight meetings its rate-setting committee holds annually, until it reached its goal.

But this time, an official survey of committee members suggests a quarter-point increase every other meeting – or four times a year – could be a likely course, inching rates higher over three years until the bank for banks reaches its stated long-term goal of a 3.5% federal funds rate.

Still, history suggests that even proceeding at that pace could help CD rates rebound from their rock-bottom levels surprisingly fast.

The period that most resembles the one ahead came in 2003-2006 when the Fed raised rates in quarter-point increments by a total of 2% a year

That’s double the speed at which interest rates are now likely to rise. But the reaction of CD rates then still provides an encouraging glimpse of how today’s interest rates could improve.

How A Rising Federal Funds Rate Influenced CD Rates 2003-2005

Target Federal Funds Rate Average 1-Year CD APY Average 5-Year CD APY
0.00% today 0.28% 0.86%
1.00% in 2003-2004 1.26% 3.02%
2.00% in 2004 1.87% 3.50%
3.00% in 2005 2.71% 3.76%
3.50% in 2005 2.95% 3.80%

As the chart makes clear, the rapid improvement of longer-term CD rates was particularly noticeable during the last period when the Fed was raising rates.

In its September forecast, the policy maker projected reaching a final federal funds target of 3.5% in 2018.

Another point of comparison: The last time the federal funds rate was that high, in January 2008, the average 1-year CD was returning 3.74% and 5-year CDs were above 4%.

It’s important to note, however, that there’s no guarantee CD rates will follow exactly the same path as before. The Fed also could choose to proceed more slowly or quickly than now expected.

Still, the change in course Wednesday reflects the Fed’s confidence that the U.S. economy has at long last grown strong enough to stand on its own feet, without the crutch of record-low interest rates.

Exceptionally low rates were needed to rescue the economy from a financial crisis and recession that began in late 2007, caused by reckless mortgage lending.

The Fed used the federal funds rate to push rates down. When commercial banks can get pretty much all the free money they need from the Fed, they don’t need our savings and can cut the interest they pay on deposits.

One measure of how little savers are being paid is the Cost of Funds Index compiled by the Federal Home Loan Bank of San Francisco. It asks banks in California, Arizona and Nevada how much they’re actually paying for deposits.

The index was a near-record low of 0.649% in October, the most recent figure available.

Back in 2008, before the Fed lowered the federal funds rate to zero, it was nearly four times higher – 2.757%.

No wonder the amount of money savers have in certificates of deposit has steadily fallen from $1.4 trillion dollars in late 2008 to less than $424 billion today.

The U.S. recession officially ended in 2009, but with the America’s economic recovery proceeding unevenly and much of the rest of the world still stuck in recession, the Fed has refused to raise rates.

But the end of the year brought a final spate of good news that apparently gave the Fed’s governors the confidence to act.

The Labor Department’s November jobs report found the economy continuing its steady growth in employment, adding 211,000 new jobs, marking 33 straight months of private-sector job growth. Unemployment remained steady at 5%.

The report also included signs that wages, which have not rebounded in the same fashion as employment, were showing signs of strengthening.

These factors were enough to bring to an end a historic stretch of Fed policy that held interest rates near zero.

Savers have waited years for a return to the days when they could earn a reasonable rate of return from the nation’s banks, or what the Fed calls a return to financial “normalcy.”

We took the first step in that direction on Wednesday.

Contributing Editor Sabrina Karl provided reporting for this post.

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  1. William said:
    on December 18th at 11:19 am

    I’m encouraged… but also not surprised to read that one of Yellen’s main reasons for increasing rates is simply so the Fed has the flexibility to lower them again if the economy begins to falter.