The Fed moved as expected by raising the federal funds rate by 25 basis points. This is the third Fed rate hike of 2017 and the fifth rate hike since the Fed started to raise rates in December 2015. Here’s that all important paragraph in today’s FOMC statement:
In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/4 to 1-1/2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation..
Two Fed officials voted against the rate hike. Chicago Federal Reserve President Charles Evans and Minneapolis Federal Reserve President Neel Kashkari “preferred at this meeting to maintain the existing target range for the federal funds rate.” Neither Fed official will be voting members in 2018.
In addition to the FOMC statement, the Fed released its economic projections which include projections for the Fed funds rate in the form of the dot plot. There is no significant change in the rate forecast from the last forecast in September. The dot plot is pretty much the same. Most participants continue to expect three rate hikes in 2018. Last year at this time, three rate hikes for 2017 was the dominate forecast, and that turned out to be correct. So we have reason to be optimistic for 2018. That’s unlike the case a year ago when we had only one rate hike in 2016 after the Fed’s December 2015 forecast had suggested four rate hikes.
Economic projections have changed since September for the better. The GDP is forecast to grow more and the unemployment rate is forecast to fall lower. However, the inflation forecast has been lowered slightly. Most participants expect PCE inflation to remain under their target of 2% in 2018. That may be an important reason that the Fed didn’t increase their forecast on rate hikes.
Future FOMC Meetings
The next three FOMC meetings are scheduled for January 30-31, March 20-21 and May 1-2. The March meeting will include the summary of economic projections and a press conference by the new Fed Chair.
How Fed Rate Hikes Impacted Deposit Rates in 2017
To predict what we’ll see in 2018, let’s review how the 2016 and 2017 Fed rate hikes have affected deposit rates.
Overall, we have definitely seen deposit rate increases this year, but I think we all are disappointed in the size of the increases. The three Fed rate hikes that occurred last December, March and June raised the target federal funds rate by 75 basis points. However, deposit rate increases have been much smaller. You can see how average deposit rates have risen this year in the following chart.
Savings Account Rates
If you look at online savings account rates at the big internet banks, rates have risen only about 25 basis points in the last year. A few examples include Ally Bank’s Online Savings Account (APY increased from 1% to 1.25%), Capital One 360 Money Market (APY increased from 1% to 1.30%) and Discover Bank’s Savings Account (APY increased from 0.95% to 1.30%).
One thing to consider is that online savings account rates never fell much below 1%. Other short-term rates were much closer to the target federal funds rate which was between 0% and 0.25%. For example, before the first Fed rate hike in December 2015, the Vanguard Prime Money Market Fund had a 0.17% yield. Yesterday, that fund yield was 1.24%. One-month T-Bill yields were similar. In December 2015, the one-month yield was 0.13%. Yesterday, the yield was 1.26%.
Competition and other factors kept online savings account rates way above of the federal funds rate during the years of the zero interest rate environment. As we’ve seen this year, the difference between the federal funds rate and internet savings account rates is narrowing. If you look back to 2006 and 2007 when the federal funds rate reached a peak of 5.25%, top online savings account rates were between 5% and 6%. Those that did offer rates above 5.25% didn’t keep that rate for long.
Like savings account rates, CD rates have also risen. However, long-term CD rates have increased less than short-term rates. We now have top nationally-available 1-year CD rates at 1.80% APY. That’s only one percentage point less than the top 5-year CD rate (2.80% APY).
This flatten yield curve is similar to the condition that existed in 2006 and 2007. During that time, the best 5-year CD rates were only about one percentage point higher than the top savings account rates.
What Savers Should Expect in 2018
Based on what we saw from the Fed today, 2018 should look a lot like 2017 in terms of rate hikes.
Now that the federal funds rate is closer to online savings account rates, we may see internet banks being more aggressive with their savings account rates than they were this year. So a year from now, we may see internet savings account rates 50 to 100 basis points higher than they are now. Sometime in 2018, we should see the return of 2% savings accounts.
We probably won’t see a similar rise on long-term CD rates. Conditions point to a yield curve that continues to flatten. I wouldn’t be surprised to see internet banks offer 2% savings accounts before they offer 3% 5-year CDs.
Deposit Account Strategies for 2018
Long-term CDs will continue to look less appealing as short-term rates rise faster than long-term rates. I still don’t think rates are rising fast enough to warrant giving up on CD ladders which are a tried-and-true way to invest in CDs. There’s currently not a big difference between the rates of top 3-year CDs (2.40%) and 5-year CDs (2.80%). So you may want to use 2-year and 3-year CDs instead of 5-year CDs for your ladder.
If you do choose mid-term or long-term CDs, make sure the CDs have early withdrawal penalties (EWPs) of 6 months’ interest or less. A long-term CD with a 6-month early withdrawal penalty can be closed early and still be a better deal than many top shorter-term CDs kept to maturity.
Another important thing to remember when looking back to 2006 and 2007 is that long-term CDs did prove to be helpful. Those with 5-year CDs that were opened in 2007 kept earning the high rate as rates fell in 2008, 2009 and 2010. That’s one reason to keep some of your money in long-term CDs even when they don’t provide much of a rate premium.
Lastly, you may find yourself keeping more cash in savings accounts. That will be tempting as internet banks come out with higher savings account rates. Choose internet banks that have no minimum balance requirements and that have solid ACH transfer capabilities. If your internet bank falls behind on rates, you’ll want to be able to easily and quickly move your money. You don’t want an internet bank that has small ACH transfer limits or slow ACH transfer speeds.