CD Rates vs. Inflation

Wade A. Barker By Wade A. Barker, 9th Sep 2011 | Follow this author | RSS Feed | Short URL http://nut.bz/22ghmvo./
Posted in Wikinut>Business>Investment

This article will compare CD rates with inflation and the effects inflation has on CDs.

Overview

According to Investopedia.com, inflation has a definition as the rate at which the general level of prices for goods and services rise, and, subsequently, purchasing power falls. A CD or Certificate of Deposit has a definition of a saving certificate entitling the bearer to receive interest, according to Investopedia.com. The CD provides an investor with a return of principle and interest while inflation reduces the purchasing power of the principle and interest.

Function

A commercial bank generally issues the CD and the CD includes insurance from the FDIC. A CD bears a maturity date, a specified fixed interest rate and a nearly unlimited number of denominations. The typical maturity date ranges from 1 to 5 years. For a healthy economy, a moderate amount of inflation is good. The incremental inflation reflects that individuals have money and have an interest in spending their money on goods and services. The incremental inflation will reflect the growth of the economy. Most economist view that a healthy, normal inflation rate should stay in the 2-5% range.

Time Frame

Since most CDs mature in 1-5 years, an investor should examine the similar time frame for their inflation concerns. The CD contains a fixed interest rate, while the rate of inflation fluctuates over time. The investor would ideally like to maintain a higher interest rate from their CD than the rate of inflation. If this does not happen, the investor has less purchasing power from their investment at the maturity date than they did at the initiation of the CD.

Feature

While most investments contain both inflation risk and deflation risk, the CD only contains the risk of inflation. The primary reason of the lack of deflation risk emerges with the FDIC insurance. The FDIC will insure the investment if the bank defaults. Most investments do not contain this insurance. Therefore, if deflation weakens the economy and businesses start to go under, the investor has the peace of mind that their investment has FDIC insurance.

Warning

While a CD contains FDIC insurance and has backing from the issuing bank, the investment has limitations. Many times the fixed rate of interest offered by the CD will be lower than other competing investments. The CD looks much like a corporate or government bond. They both offer a fixed interest rate with the coupon or principle investment returned at maturity. The corporate or government bonds do not contain FDIC insurance. Though the federal government does back the U.S. treasury bond and will ensure the interest payment and coupon payments are paid.

Considerations

An investor needs to do their homework. Examine competing products like short-term U.S. treasury bonds and competing banks, as some banks offer different interest rates on their CDs. Also, the investor should read all of the fine print on the Certificate of Deposit. Most contain a clause pertaining to early withdrawal penalties if the investor needs the money before the maturity date. A prudent investor will have access to liquid funds so they don’t need to pull the money out of the CD in a financial emergency.

Reference

Investopedia: http://www.investopedia.com/terms/c/certificateofdeposit.asp

Tags

Cd Rates, Cds, Inflation, Inflation And Higher Rates, Inflation Rate

Meet the author

author avatar Wade A. Barker
Wade Barker has over 15 years of experience in the stock market, the U.S. and world economies. He worked for a technology fund of a large mutual fund company managing $11 billion.

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