Action by Fed Is Likely to Lift Consumer Rates

Savers can count on higher returns on their cash in coming months, while borrowers may have to shell out more for loans, after the Federal Reserve on Tuesday again lifted its key short-term interest rate -- and appeared to promise more to come.

The increase in the Fed’s benchmark rate, from 1.25% to 1.5%, is likely to cheer millions of savers who had been earning rock-bottom returns on bank certificates of deposit and other so-called cash accounts for the last two years.

Those yields have been climbing since spring, when the Fed began to warn financial markets that it was poised to tighten credit. The central bank’s first move was on June 30, when its key rate went from 1% to 1.25%.

To be sure, savers aren’t getting rich overnight. The average annualized yield on one-year CDs now is 1.63%, according to rate tracker Informa Research Services in Calabasas. That’s up from 1.26% in late March, but a far cry from the rates many Americans remember earning in the 1990s.

Still, for savers on fixed incomes, every dollar of extra interest income can help.

The Fed’s benchmark rate, the so-called federal funds rate, is what banks charge one another for overnight loans. By influencing that rate, the Fed effectively determines the direction of all other short-term rates.

But banks usually are much quicker to change their short-term lending rates than their deposit rates when the Fed moves.

Within hours of the Fed announcement Tuesday, a number of major banks, including Bank of America, Wells Fargo and Comerica Bank, raised their prime lending rates from 4.25% to 4.5%. A higher prime rate will mean rising loan payments for many consumers who have home equity credit lines and credit card rates tied to that rate.

Rates on savings, by contrast, tend to rise incrementally. For example, in the week after the Fed’s quarter-point rate hike June 30, the average one-year CD yield edged up from 1.51% to 1.54%, according to Informa Research.

“CD yields have continued to improve, slowly but steadily,” said Greg McBride, senior analyst with BankRate.com, a rate-tracking firm in Florida.

Yields are likely to continue to rise well into 2005, if the economy remains on a growth track: The Fed reiterated in its statement Tuesday that it expected to continue tightening credit at a “measured” pace.

Fed Chairman Alan Greenspan and peers don’t appear to be worried that the weak job growth the government reported for July means the economy is entering a sustained slowdown.

“The surprise of the meeting was that the language of the Fed’s statement was a little bolder” than expected in terms of optimism about the economy, said Michael Roberge, chief fixed income officer at MFS Investment Management in Boston.

Many economists believe that will mean quarter-point hikes in the Fed’s key rate at each of its policymaking meetings through mid-2005, at least. The meetings occur every five to seven weeks; there are three left this year -- Sept. 21, Nov. 10 and Dec. 14 -- and four in the first half of 2005.

That could mean that the federal funds rate would be 3.25% by June 30 of next year, if all goes well with the economy. The prime rate then would be 6.25%.

Bank CD and other deposit rates also would be substantially higher than current levels.

Because rates are expected to continue rising, many financial advisors say savers should avoid locking up too much of their money at current rates. Many favor a “laddered” approach with CDs -- for example, dividing money among three-month, six-month, nine-month and one-year CDs, so that some savings is regularly rolling over.

But locking in some yields now would offer a hedge in case the economy softens and the Fed postpones further rate increases, analysts note.

There are signs that more people are beginning to warm to CDs. The total in small CDs (those under $100,000) at banks and thrifts had been falling since 2000, according to data from the Federal Reserve Bank of St. Louis. But in recent weeks CD assets have flattened at just under $800 billion.

Many Americans in recent years have simply pumped spare cash into regular bank savings accounts. Yields on those accounts remain well below 1%, on average.

Savers who don’t want to lock up their cash should consider money market mutual funds, many experts say. Yields on those funds, which buy short-term government and corporate IOUs, usually fully reflect Fed rate changes, though with a lag of six to eight weeks.

The average annualized yield on money funds now is 0.77%, up from 0.53% in early June, according to IMoneyNet Inc.

Savers who like to play it safe have other options as well, including U.S. Treasury bills (for $10,000 or more). The yield on six-month T-bills now is 1.75%, well above the average six-month bank CD yield of 1.25%.

Ray Montague, manager of deposit research at Informa Research, said savers who want to stay in banks should take the time to shop around for the best yields; many banks pay well above the national averages for CDs, he said.