Should You Be Worried About Low CD Rates?

A recent trip to my credit union to purchase a CD was a surprise. A 3-month CD yielded a measly 1.32 percent. A 5 -year CD wasn't much better at 3.43 percent. But these low rates got me thinking about another rate and that's the inflation rate. (See: http://www.inflationdata.com/inflation/Inflation_Rate/CurrentInflation.asp for the raw inflation data.). The annualized inflation rate for the month of September 2009 was -1.3 percent. That "minus" means that goods and services cost an annualized 1.3 percent less in September 2009 than they did the year before. So if I had a 3-month CD which paid me an annualized rate of 1.32 percent in this inflation environment, my "real" annualized yield for the month of September 2009 would be 2.62 percent (i.e., 1.32-(-1.3)= 2.62). If I had a 5-year CD my "real" annualized yield for the month of September 2009 would be 4.73 percent. Not bad!

Consider the same CD in January 2006. According to government statistics (the Federal Reserve's H.15 publication), in January 2006 a 3-month CD yielded 4.56 percent. That month the inflation rate was 4 percent, meaning that the saver's "real" annualized yield for that month was only .56 percent.

So, while today's CD rates seem low, the "real" return to the saver is much more than they were in 2006 (after taking the inflation rate into account). In fact, a few quick calculations shows that 2009 is turning out to be a much better year for CD investors, if you consider the CD return over inflation, than the 3 previous years.

I compared the 3-month Certificate of Deposit Index (CODI) (calculated by averaging the previous 12 rates of the 3 month CD rate. which is less volatile than straight CD rates) for each of 2006 through 2009 and compared it to the inflation rate for the same periods, I found the annualized returns over the inflation rate for 2006, 2007, 2008 and 2009 were 1.267, 2.432, 0.156 and 3.116 percent, respectively.

So the low CD rates offered by banks and credit unions aren't as bad as the seem at first blush. In addition, when you consider the taxes you pay on your returns, today's inflation (or rather, deflation) environment is even better.

Lets say for simplicity that the 3-month CD rates held steady at 4.56% and 1.32% for the whole year in 2006 and 2009, respectively, and similarly the inflation rates for those years held steady at 4% and -1.3, respectively.

Back in 2006 let's assume you put $100 in a one year CD which paid 4.56% interest. So you "earned" $4.56 on your CD for that year and paid taxes on that amount. Let's say you were in the 30% tax bracket and paid 30% of that $4.56 (or $1.39) to the government in taxes. But remember that in 2006 the inflation rate was 4% and therefore your "real" return after inflation on your $100 CD was only $0.56. Yet you paid $1.39 in taxes! So for 2006 you lost $.81.

Let's go forward to 2009 when you will "earn" only $1.32 on your $100 CD, pay your 30% taxes of $.40 for a net of $.92. But, after considering that inflation is only -1.3 in 2009 your "real" return after inflation in 2009 will be $2.22!

Do I have this math all wrong? It seems to me that 2009 will turn out to be a good year for CD investors (assuming, of course, that the inflation rate (or, rather, the deflation rate) doesn't change.