When the Federal Reserve changes interest rates, consumers feel the ripple effects in a variety of ways.
For depositors, banks offering the best interest rates tend to get higher rates when the U.S. central bank raises them and lower rates when it cuts them. The Fed decided to keep interest rates steady at its June meeting, effectively keeping the federal funds rate in a range of 5.25% to 5.50%.
The Fed opted to keep rates on hold at its four rate-setting meetings, in May, March, January and again in 2023. It also raised rates by 25 basis points in July, May, March and January last year. The Fed will raise rates a total of 11 times in 2022 and 2023.
“Where you park your cash really matters,” says Greg McBride, CFA, chief financial analyst at Bankrate. “The best places to park your cash are with the highest-yielding savings accounts and term deposits, as they are the banks that are raising dividends and staying competitive for depositors' funds. Many banks, especially the larger ones, have been pretty reluctant to pass on higher interest rates to depositors.”
For those who make saving money a top priority, here's what to consider when the Fed changes the federal funds rate:
The loose connection between Fed rate hikes and high-yield savings accounts
Congress mandates that the Fed maintain economic and financial stability. The central bank does this primarily by raising and lowering borrowing costs. Interest rates on savings accounts are loosely tied to the interest rates set by the Fed. When the central bank raises interest rates, financial institutions tend to pay higher interest rates on high-yield savings accounts to remain competitive and attract deposits. Conversely, when the Fed lowers interest rates, banks tend to lower interest rates on savings accounts.
In March 2020, the federal funds rate was lowered to the zero to 0.25% range in response to the COVID-19 pandemic. However, in response to the highest inflation in 40 years, the Fed will raise interest rates by 4.25% over seven meetings throughout 2022, including four hikes of 0.75% each. In 2023, there will be a total of four 0.25% hikes.
Policymakers' decision to keep interest rates unchanged for a seventh consecutive session comes at a time when annual inflation, currently at 3.3%, is not falling as rapidly as it once did. As a result, competitive banks are offering the highest yields on consumer deposits in more than a decade.
Online banks tend to compete for customers with relatively high interest rates, while brick-and-mortar banks tend to avoid paying competitive yields to depositors. Savings account interest rates vary widely and are subject to change at any time. While large brick-and-mortar banks such as Chase and Bank of America still offer annual percentage yields (APYs) of around 0.01 percent, the top high-yield savings accounts offer APYs of up to 5.30 percent, which is a 530x return.
Increasing competition is one reason for the yield disparity: Online banks are struggling to attract and retain depositors as fintech competitors continue to enter the market. Offering high-yield accounts is one tried-and-true strategy, especially for smaller, newer digital banks, to lure customers with attractive offers.
Deposits are generally essential to banks' business models and are used as a low-cost source of funds to stimulate loan demand.
“Bankers don't just take deposits because they're cool,” says Neil Stanley, CEO and founder of CorePoint, a bank management services company. “Bankers take deposits because they can invest those deposits in loans.”
If banks are making a profit by investing deposits in loans, they can afford to pay more for deposits. Spoiler alert: banks are (usually) making a profit.
Not all banks are hungry for more deposits. Whether and when banks respond to Fed interest rate changes depends on the goals they are trying to achieve. Online banks, which are often hungry for more deposits, are more likely to follow suit if the Fed raises rates, but traditional brick-and-mortar banks tend not to respond to Fed rate hikes by raising their own savings rates.
“Different banks may be feeling a little bit of pressure,” said Betty Cowell, a former senior adviser at consultancy Simon-Kucher & Partners.
How to Maximize Your Savings Rate
While the average yield on a traditional savings account is just 0.58 percent, some banks offer high-yield savings accounts that earn around 5 percent annual interest, or nearly 9 times the amount you would earn on a regular basis. While these accounts won't do much to beat the high prices at the gas station or grocery store, they can help you earn some income.
“With online savings accounts offering yields above 5 percent, your emergency fund will no longer be a drag on your portfolio,” says McBride. “The main benefit of emergency savings is that you have immediate access to cash when unexpected expenses arise to protect yourself against costly debt or forced asset sales, but you continue to be compensated for your savings in a way you haven't been able to for over 15 years.”
Online banks are known for offering the highest interest rates, but it's worth shopping around. Also, consider cash management and money market accounts to find the best terms. If you can park your cash for a set period of time, consider a short-term CD.
“For investors looking for predictable interest income, CDs offer that, without the price fluctuations and default concerns that come with many bonds,” McBride says. “But don't sacrifice emergency savings in pursuit of CD yields unless your bank offers a way to cash out early without penalty if you need the money.”
When searching for the best bank account for you, keep the following in mind:
Compare APYs Read the fee fine print Understand minimum balance requirements Make sure your account has the features you need
“If you're shopping in the market today, compare prices online and choose a trusted brand,” Cowell said.