How Fed Rate Cuts Affect Fixed Deposit Rates

The U.S. central bank, the Federal Reserve (the so-called “Fed”), currently effectively controls the nation’s money supply through the manipulation of interest rates. When it makes an interest rate cut, this has consequences for many different types of investments, including personal savings deposit accounts at commercial banks. Briefly, when the Fed raises interest rates, interest rates on fixed deposits (like Certificates of Deposit in America, and Guaranteed Investment Certificates in Canada) and high-interest savings accounts rise. However, when the Fed makes a rate cut, interest rates on those products fall.

– How the Fed’s Interest Rates Work –

In addition to controlling the currency, the Federal Reserve is essentially a bank to the banks: it accepts deposits from them, makes loans to them, and assesses interest on those transactions. When the financial media refers to the Federal Reserve making a rate cut, it is the interest rates on those transactions which the Federal Reserve is adjusting.

The Federal Reserve technically has no control over any other interest rates in the broader economy: it cannot, for example, dictate to a private bank what that bank’s interest rates should be. However, by setting its own interest rates, it can in effect alter the value of money for private banks. If interest rates are very low (in the most extreme case, zero, as the Japanese and most recently American central banks did in response to credit crises), then suddenly loaning money from the central bank becomes very attractive to the banks. If interest rates are high, then they are less likely to make those loans. In essence the banks respond to the central bank’s interest rates in the same way as we respond to private banks’ rates: when they are low, we’re more willing to take out debt than when they’re high.

– How This Applies to Fixed Deposit Rates –

Thanks to a practice called fractional reserve banking, when you deposit money in a bank (either in a savings account or in a fixed deposit account, like a CD), it does not simply sit in the bank’s coffers. Instead, the bank loans out the majority of the money to other customers. It is legally required to deposit 10% of new assets with the Federal Reserve as a demonstration of solvency and good faith, and will probably hold some more back to cover the administrative costs of its banking network and employee salaries. The rest, however, can be loaned to other customers. In effect, when you deposit money in a bank, you are actually loaning the bank money. This is why banks pay interest rates to their clients: it is a small reward taken out of the much larger profit the bank makes from loaning out your money at interest to its other clients.

What this ultimately does, however, is that it puts bank clients into the credit market along with the bank’s various other sources of capital for loans – and, most importantly, with the central bank. After a Fed rate cut, it becomes much easier to acquire a large amount of money from the central bank. As a result, your money becomes less attractive to your bank, because it can easily get money from elsewhere. The bank responds by cutting interest rates, including on fixed deposits. The reverse is also true: when the Federal Reserve makes a rate hike, banks will usually respond by raising their own rates as well.

A fixed deposit, like a CD in America or a GIC in Canada, will usually pay out at a pre-established rate for its entire term, whether that term is six months or five years. For this reason, once you have purchased such an investment, the interest rates will not fluctuate, as they do for regular savings accounts. Nevertheless, the interest rate which the bank sets at the beginning of such an investment will reflect a combination of what the Federal Reserve interest rate is at that point in time, and also where the bank thinks the interest rates are likely to go in the future, over the course of the investment. A Fed rate cut therefore means that interest rates on new deposits will probably fall. If banks believe they can get cheap money from somewhere else, they’ll be less likely to want to compete for yours.