The Federal Reserve Could Raise Interest Rates Again This Month. Here's How It'll Impact Your CDs

After pausing its rate-hike cycle at its June meeting, the Federal Reserve is widely expected to increase the benchmark federal funds rate at its meeting later this month. In fact, according to CME's FedWatch tool, markets are pricing in a 92% chance of another 25-basis-point (0.25%) rate hike in July.

If you're in the market for a CD, you might be wondering whether yields will become even higher if the Fed raises rates. Unfortunately, the answer isn't a simple one, but here's a rundown of what you need to know.

The relationship between CD interest rates and the Fed

The key point to know before we dive in is that CD interest rates are not directly tied to the Federal Reserve's interest rate moves. For example, if the Fed increases the federal funds rate by 50 basis points (0.50%), that doesn't mean your bank's 1-year CD rate is going to rise by the same amount.

Having said that, the two tend to move in the same direction. Since early 2022, the national average yield on a 1-year CD has increased from 0.27% to 1.66%. And this includes CDs offered by branch-based banks, which tend to pay relatively low interest rates -- the yields from our favorite high-yield CDs have increased even more sharply in the current rate hike cycle.

CD rates and future expectations

It's important to consider the underlying reasons banks increase deposit rates when the Fed raises benchmark interest rates. Specifically, when the Fed raises rates, the yields paid by risk-free instruments like short-term U.S. Treasuries increase, and in order to remain competitive for deposits, banks tend to raise their rates accordingly.

So, while there is no rule that says banks have to give depositors more money just because the Fed raised rates, in practice that is generally what happens. High-yield savings accounts tend to see the closest relationship, but CD rates tend to rise along with the Fed's moves as well.

However, because they lock in rates for a certain amount of time, CD rates tend to be a combination of the current interest rate environment and future expectations for rates.

Think of it this way: The Fed is expected to keep rates rather elevated for at least the next year or so. The median expectation for May 2024 is a federal funds target range of 5% to 5.25%, exactly where it is now. So, the yields paid by our favorite banks on 1-year CDs range from 4.5% to 5.3% as of this writing.

However, the current expectation is that the Fed will start to lower rates by mid-2024 and continue to do so for the foreseeable future. By the end of 2024, the median expectation calls for a federal funds rate of a full percentage point below where it is now. So, while there is not a direct relationship with CD yields, this future expectation of lower rates is the biggest reason why our top 5-year CDs have yields ranging from 3% to 4.35% as of July 10 -- significantly below the available rates on 1-year CDs.

The bottom line

To sum it up, if the Fed raises interest rates again in July, there's a good chance that the CD interest rates offered by financial institutions will also trend upward. But there's a lot more to the story. Shorter-term CDs tend to be much more sensitive to the Fed's interest rate moves, while longer-maturity CDs tend to be a bit more forward-looking.

In a nutshell, the biggest advantage of using a CD instead of a savings account is that if rates fall, you've locked in an interest rate for a certain period of time. On the other hand, one of the biggest drawbacks is that if interest rates rise, you don't benefit. Nobody knows what the Fed will do, but the CD interest rates paid by some of the top banks today are significantly higher than they were. With the Fed widely expected to start lowering interest rates within the next year, CDs could be a good way to lock in a high yield on your savings, regardless of whether the Fed raises rates in July.