How Inflation Is Affecting Money Market Funds

The stock market has not brought much joy, bonds have been a source of considerable pain, and inflation is a concern.

But there’s finally a glimmer of good news for people who need a place to park their cash: Money market mutual funds are finally starting to pay a little interest.

These funds are a convenient place for both individual investors and large institutions to stash money temporarily. Its yields have been very low for years and, since the crisis of March 2020, have hovered near zero, paying virtually nothing to investors.

But now that the Federal Reserve has begun to raise short-term interest rates that it directly controls, the yields on money market funds that are available to consumers have also begun to rise, and will continue to rise as long as the Federal Reserve continues to raise short-term interest rates. – Term rates.

“Money market rates can be expected to continue to rise for a while,” said Doug Spratley, who leads the cash management team at T. Rowe Price. “And they will increase quite quickly.”

Don’t get too excited yet. This is not a throwback to the early 1980s, when money market rates soared above 15 percent, along with the rate of inflation. The average large money market fund’s return is still only about 0.6 percent, said Peter G. Crane, president of Crane Data of Westborough, Massachusetts, which oversees money market funds.

“Yields are moving in the right direction,” Crane said. “But that’s still not much, especially when you factor in inflation.”

The Consumer Price Index has been running at an annual rate of over 8 percent, creating a huge gap between inflation and money market returns. That’s not good for your personal wealth, to say the least. Rather, it indicates that its real rate of return, adjusted for inflation, is deeply negative. In other words, the longer you keep your extra money in a money market fund, the less purchasing power it will have.

Money market yields will not stay where they are for long. On Thursday, the Fed is likely to raise rates again, and money market rates should follow, with about a month to go.

How this happens is a bit tricky, so bear with me for a quick dive into the financial plumbing.

What will draw more attention on Thursday is that the Fed will raise the benchmark federal funds rate, probably by 0.5 percentage point, to a range of 1.25 to 1.50 percent. Come July, that’s expected to happen again, with more raises to come. Traders are betting the fed funds rate will top 3 percent in 2023.

But the Federal Reserve has also been raising other interest rates, including one with a shady name: the reverse repurchase agreement, also known as the reverse repo rate.

That rate sits at 0.80 percent, but it was close to zero for months. Money market mutual funds receive that rate for funds held by the Federal Reserve overnight, so it works as a rough floor for returns.

For the time being, short-term Treasury bills, with yields in the range of 0.85 to 1.05 percent, provide a practical ceiling, especially for funds that hold government securities.

As I wrote when interest rates fell to near zero in 2020, money market fund operating expenses exceeded the income they generated. That meant, in theory, that the funds could have resorted to paying negative returns to make money, which would have resulted in fund investors paying for the privilege of parking their cash in a money market fund. Negative rates did not occur in the United States. The fund companies provided expense waivers (effectively subsidies) to keep the funds in business.

The rise in short-term interest rates has alleviated this particular crisis. From here, the fate of money market funds rates depends on the arc of inflation and the response of the Federal Reserve.

In practice, in today’s unstable markets, many people need good places to store their short-term cash. In the past, I’ve noticed that various options, such as bank accounts and Treasury bills, seemed reasonable. I would now add money market funds to that list, with a few caveats.

Keep in mind that aside from returns, money market funds ran into some safety issues in the last two financial crises. Since then, they have been subject to stricter regulatory scrutiny and a series of reforms.

Many funds now hold only US government securities, and all are required to hold only high-quality debt instruments. All are meant to avoid fluctuations in value, although they have been under pressure before and may well do so again. In either case, money market funds are safer than stock or bond mutual funds or exchange-traded funds.

I asked Mr. Crane, who has closely monitored money market funds for decades, if he recommends them.

“At this point, I think they are as safe as anything else,” he said, but added that government-insured bank accounts “have a slight security advantage.” Still, he said, if we ever find ourselves “in a situation where money funds are losing a lot of value, you’ll have a lot of other issues to worry about, like finding your modern wellies and making sure you have enough canned food.” .

I would put it this way: the odds of losing money in a money market fund are low. In another big financial crisis, they may well be in trouble again, but the government has always stepped in to fix them.

There are other options to safely hold short-term money. Simply put, they include US government I bonds, which yield a staggering 9.62 percent, a rate that resets every six months. They are very safe but imperfect, especially for short-term purposes. Not only are there limits on the amounts you can buy, but there are also small penalties if you cash them in before five years.

Bank accounts are extremely safe, even if the interest that most pay is very low. A survey by found that the average return on savings accounts in the United States was just 0.07 percent. Some online bank accounts have higher returns; in some cases, they are around 1 percent. Short-term bank certificates of deposit, Treasury bills, and high-quality short-term corporate bonds are also available. All of these rates are increasing.

The yields money market funds pay right now are below those of Treasuries and corporate bonds or commercial paper, but with rates that fluctuate, the funds have a huge advantage. The fund manager may exchange higher interest Treasury bills or commercial paper as they become available. I’m not willing to spend time doing that myself. I’d rather let a fund manager do the work for me.

As usual, Vanguard’s fund expenses are low, which enhances the fund’s returns: The Vanguard Federal Money Market Fund has a return of 0.72 percent. The T. Rowe Price Cash Reserve Fund, which Spratley manages, is close at 0.66 percent. The Fidelity Money Market Fund has a yield of 0.60 percent. Virtually all major asset managers offer money market funds.

Once you start looking at them, you will find that the returns increase regularly.

Who knows where they will be next week? It’s almost exciting.

Remember, however, that these returns are still extremely low. They don’t keep up with inflation, and if they eventually do, that’s probably not good news either.

Imagine that in the not too distant future the Federal Reserve manages to reduce the rate of inflation close to its target rate of 2 percent. However, to do this, he is slowing down the economy, perhaps even driving it into a recession. That is not cause for celebration.

But as soon as a slowdown becomes apparent, the Fed is likely to start cutting rates, creating an opportunity for nimble money market fund managers. They can extend the length of their holdings for the yields to delay the decline in money market yields for up to two months. So you could be outpacing inflation, but only by a small amount. And with a slowing economy, you’ll have plenty of other things to worry about.

For now, try to enjoy the spectacle of rising money market rates without falling prey to what US economist Irving Fisher called “the money illusion.” Don’t forget that in real terms, you are losing money.

Yields on money market funds are improving, yes, but as an investment they are still a bad idea.

Leave a Comment

Your email address will not be published.