Credit union members and bank customers were clearly anticipating that inflation would rise in late 2009 or early 2010 due to the massive liquidity in the market. That reduced the appeal of locking in short-term deposits at relatively low interest rates. It's important to note that only short-term deposits (up to one year) are on the decline. Anticipating higher interest rates, credit union members and bank customers continue to shy away from short-term deposits. They realize that as long as deposit rates remain low, the net return on their money is going to stay in negative territory when adjusted for inflation.
Deposits of more than one year showed a modest gain in balances, which could mean that consumers expect the Federal Reserve to increase the Fed funds rate at some point, which would push deposit rates back up and inflation rates down. Thus, CDs that will mature in a year or two, when deposit rates are higher and inflation is lower, are likely to yield a positive return.
Analysts project that the annual inflation rate will continue to rise for most of 2010, as long as the Fed funds rate is unchanged. Recently, the Fed signaled that it is considering an alternative to the "traditional" funds rate increase in order to absorb some of the excess liquidity in the market and control inflation. This new approach consists of raising the rate that the Fed is paying banks on reserves deposited in the central bank, which is currently 0.25 %. By raising that rate, the Fed expects to encourage banks to deposit more of their money with the central bank, which achieves the goal of taking money out of the market. As of February 2010, reserves deposited at the Fed amounted to $1.1 trillion.
Here are some potential scenarios that could impact deposit balances in the coming months for credit union members and bank customers.
Increase only in the Fed funds rate. This is a remote possibility in the short term because traditionally the Fed has avoided raising rates during economic recoveries. The high unemployment rate (9.7 % in January 2010) combined with a sluggish lending environment and a historically low real estate market makes raising the fund rate unlikely in the short term.
Increasing the rate would trigger an increase in the lending rates and consequently deposit rates. However, even if the increase is aggressive (75 basis points, for example), the current situation of net negative returns for deposits would remain the same. Currently, the gap between the average yield on deposits and the annual inflation rate is a negative 126 basis points. This means that in order for deposits to yield a positive return, this gap will need to be closed by higher deposit rates and lower inflation rates.
Increase in both the Fed funds rate and the reserve rate. This is a more likely scenario in the short term because it allows the Fed to modestly increase the fund rate, but at the same time absorb some of the liquidity in the market by offering banks a higher rate on their reserves. The current reserve rate is 0.25 %. Increasing it will attract additional reserve capital from the banks, which is likely to reduce the rate of inflation. Here, too, the dual approach can take some time to reach the point of zero net return. It is unlikely that this equilibrium will be achieved during 2010, thus encouraging consumers to shy away from any term deposits that will mature in 2010.
No change in any of the Fed's rates. This scenario is also likely in the short term. Again, the current economic indicators are not very favorable to increasing the fund rate-especially not in the second half of 2010, when mid-term elections are taking place. Traditionally, the Fed eschewed implementing monetary policy close to elections in order to avoid the appearance of political bias. If no change in any of the Fed's rates takes place in 2010, short-term deposits are likely to continue to decline due to the net negative returns that they offer.
The recent increase of 25 basis points in the discount rate is not considered significant or relevant to deposit interest rates. The amount of money that is impacted by the discount rate is currently $14 billion-an insignificant amount relative to the $1.1 trillion in reserves that banks have with the Fed.
In summary, there is a very strong likelihood that short-term deposits (up to one year) are going to be less in demand during most of 2010. It is also conceivable that short-term deposit balances, as well as liquid deposits, will move out of insured deposits and into investment channels such as mutual funds, stock or commodities.
Dan Geller is executive vice president of Market Rates Insight. He can be reached at 415-448-8813 or firstname.lastname@example.org.