Here's What Could Happen to CD Rates if the Fed Cuts Interest Rates Next Month

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The economy is looking as if it's starting to slow, with lower inflation and higher unemployment. As a result, it's a virtual certainty at this point that the Federal Reserve is going to cut interest rates at its next meeting in September. The financial markets are pricing in a 100% chance of this happening -- the median expectation is for two full percentage points in interest rate cuts in the next year.

You've probably noticed that certificate of deposit (CD) interest rates -- especially for shorter-term CDs -- are far higher than they were just a few years ago. This is because since the beginning of 2022, the federal funds rate (the interest rate people are referring to when they say "the Fed raised rates") has increased by more than five percentage points.

With the Fed now set to cut rates for the first time since the March 2020 onset of the COVID-19 pandemic, what will it mean for CD rates?

What would happen to CDs?

In general, CD yields fall into two categories when it comes to how reactive they are to interest rate movements. Shorter-term CDs tend to have yields based on current interest rates. Longer-term CDs, on the other hand, tend to have yields based on expectations of interest rates through their term. This is why 5-year CDs currently pay less than 1-year CDs at most banks.

Generally speaking, CD yields tend to move in the same direction as benchmark interest rates like the federal funds rate. But the changes tend to be the fastest among the lower maturities.

So, if the Fed cuts rates in September by 0.25 percentage points (a movement of 0.25% is considered to be a standard Fed rate movement), it would likely make short-term CD yields decline by roughly the same amount at the top online banks. On the other hand, rates paid on 3- and 5-year CDs would likely decline, but to a lesser extent.

Having said that, it's important to point out that CD rates, as well as savings account interest rates, are set by the financial institutions that offer them. And while banks generally base these rates on benchmark rates, they aren't required to do so. For example, if a bank has a 4.5% 1-year CD rate and the Fed cuts rates by 0.25%, that bank could choose to leave its rate as is. In other words, even if we know exactly what the Fed will do, predicting CD interest rates isn't an exact science.

The bottom line

If the Fed cuts rates in September, whether by 0.25% or 0.50%, the likely impact on CD rates would be to lower them, but by a rather small amount. However, the key point is that the Fed isn't expected to simply be one-and-done with rate cuts -- this is likely to be the first step in a cycle of rate cuts that is expected to last for well over a year.

So while we aren't likely to see a big knee-jerk reaction from CD rates, we are likely to see them continually trending downward through at least the end of 2025, and perhaps beyond.

The bottom line is that if you have cash sitting on the sidelines, CD yields are highly unlikely to get any higher, so it could be a smart idea to check out some of the top CD rates and lock them in right now. However, the decline in CD rates is likely to be a gradual one, so there will still be some income opportunities for new CDs in the years ahead.

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