For most consumers, “inflation” means an increase in the cost of goods and services. When the price of tomatoes and coffee goes up at the local store, we recognize that inflation is at work. But to an economist, inflation also describes a trend in which money loses some of its “real value” in the market. When prices rise, each unit of currency has less purchasing power than it did previously. The main way economists measure this purchasing power is through something called the “inflation rate,” which is calculated as the percentage change of a price index over time – most often, the consumer price index.
The inflation rate is used to calculate the interest rates charged by your bank, which adjusts accordingly to inflation. CD interest rates and the inflation rate usually track very closely together. If inflation is at 15%, most banks’ CD interest rates will be very close to 15%. If inflation is two percent, interest rates will be two percent, and so forth and so on. What this means to you, the consumer, is that the “real rate of return” on your CD is just barely keeping pace with inflation. The actual value of the CD interest rate is not in the number or percentage, but in its relative value to the inflation rate of the consumer price index.
For instance: let’s say you have a $500 CD that matures in 5 years. If it has kept pace with inflation, when you cash it out on its maturity date, you will be able to buy the same amount of tomatoes with it that you would have been able to buy with $500 five years ago. Whether it collected interest at 15% or 2%, the “real rate of return” will be the same.
In reality, of course, not all banks pay the same interest rates and this criticism only applies to the “average” CD interest rates. Also, if you lock in a good rate on a long term CD at a time when interest rates are high, the final real rate if return could end up being much higher than the national average. For the best CD interest rates, shop around and compare among financial institutions before making your decision.