The Fed dropped the federal funds target rate by a whopping 125 basis points in ten days, resulting in a variety of CD rates to fall way under 5%. For the income investor, Certificates of Deposit have always been a nice “base” onto which to build your income generating retirement portfolio so this past week’s moves likely has put a bit of a dampener on your portfolio. I wouldn’t worry just yet because there are still CDs out there, such as Countrywide’s, with rates closer to 5% than 4%, so the bottom hasn’t fallen out yet.
I currently use a CD laddering strategy where I bought small amounts each month such that each “rung” comes due. It’s like making a CD more liquid than it really is because instead of 1 CD for $12000, I have 12 CDs at $1,000 each. So in March 2008, my 12 month CD opened in March 2007 will mature. What I will do is then turn around and put that money back into yet another 12 month CD. Each month a rung will mature and I’ll reinvest it. It gives me the flexibility of access with the higher rates for a longer term CD.
I won’t be going with a longer term CD because you never know the full effects of a rate drop, specifically with respect to inflation, for at least 12 months (that’s what the experts say). See, when the Fed drops the target rate, it means that they are pumping more money into the system. This additional money may be exactly what’s needed by the banks, or it could be more. If it’s more, they lend it out, people spend it, demand for goods and services increases, and inflation results. Moderate inflation is good, but if they pump too much money in then inflation may be higher than moderate – that’s bad. Anyway, if inflation picks up too much then CD rates will increase and you may be locked into a longer term CD than you want. Ultimately that’s for you to decide.