How Inflation Can Change Where You Put Your Cash

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

These funds are a convenient place for both individual investors and large institutions to temporarily hold money. Their yields have been very low over the years, and since the March 2020 crisis, they have been hovering near zero, offering investors almost nothing.

But now that the Federal Reserve has begun to directly regulate short-term interest rates, the yields of money market funds available to consumers have also begun to rise — and will continue their climb as long as the Fed continues to grow lower. -Term rates.

“You can expect money market rates to rise for some time,” said Doug Spratly, head of the cash management team at T. Rowe Price. “And they must be growing quite fast.”

Don’t get too excited right now. This is not a return to the early 1980s, when money market rates exceeded 15% along with the rate of inflation. The yield on the average large money market fund is still only 0.6%, said Peter Crane, president of Crane Data of Westboro, Massachusetts, which tracks money market funds.

“Yields are heading in the right direction,” Crane said. “But it’s still not much, especially when you look at inflation.”

The latest Consumer Price Index numbers released on Friday showed inflation at 8.6% annualized in May, creating a wide gap between inflation and money market yields. This is not good for your personal assets, to say the least. Conversely, it indicates that your actual rate of return, adjusted for inflation, is deeply negative. In other words, the longer you hold your excess cash in a money market fund, the lower your purchasing power.

Fed’s role
Money market returns won’t stay where they are for very long. On Wednesday, the Federal Reserve is expected to raise rates again, and money market rates should follow, with a lag of about a month.

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

What will get the most attention on Thursday is that the Fed will raise the benchmark federal funds rate perhaps 0.5 percentage points from 1.25% to 1.50%. In July, this is expected to happen again, with more increases to come. Traders are betting that the federal funds rate will go above 3% in 2023.

But the Fed is raising other interest rates as well, including one with a depressing name: the reverse repurchase agreement, aka the reverse repo rate.

The rate is 0.8%, but was close to the zero threshold for months. Money market mutual funds receive that rate for funds held overnight by the Fed, so it serves as a rough floor on yields.

Currently, short-term Treasury bills, with yields in the range of 0.85% to 1.05%, provide a practical range, especially for funds that hold government securities.

As I write, when interest rates dropped to nearly zero in 2020, money market funds’ operating expenses exceeded the income they brought in. This meant, theoretically, that the fund would have resorted to negative yields to make money, which would result 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. Fund companies exempt expenses — effectively, subsidies — to keep the money in business.

The rise in short-term interest rates has compounded that particular crisis. Where money market fund rates go from here depends on the inflation arc and the response of the Federal Reserve.

a place for cash
As a practical matter, in the current volatile markets, many people need good places to keep their short-term cash. In the past, I noticed that many options — such as bank accounts and Treasury bills — seemed reasonable. Now I will add money market funds to that list with a few qualifications.

Keep in mind that money market funds have been facing some security problems over the past two financial crises. Since then, they have been subjected to strict regulatory scrutiny and a series of reforms.

Many funds now only hold US government securities, and all are required to hold only high-quality debt instruments. Everyone’s intention is to avoid price volatility, although they have been stressed before and may do so again. In either case, money market funds are safer than bond or stock mutual funds or exchange-traded funds.

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

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

I’ll put it this way: Money market funds have a low probability of losing money. In another major financial crisis, it is quite possible that they may run into problems again, but the government has always stepped in to fix them.

There are other options for keeping short-term money safely. In a nutshell, these include US Government I bonds, which yield an astonishing 9.62%, a rate that is reset every six months. They are very safe but imperfect, especially for short term purposes. Not only are there limits to the amounts you can buy, but there are also small penalties if you redeem them before five years.

Bank accounts are extremely safe, even though the interest payments are very small. A Bankrate.com survey found that the average savings account return in the United States was only 0.07%. Some online bank accounts have higher returns; In some cases, they are about 1%. Short-term bank certificates of deposit, Treasury bills and high-quality short-term corporate bonds are also available. All these rates are increasing.

At the moment the returns paid by money market funds are lower than Treasury bills and corporate bonds or commercial paper, but with rates fluctuating, the fund has a major advantage. Fund managers can swap in high-interest Treasury bills or commercial paper when they are available. I’m not willing to spend the time doing this myself. I would rather let a fund manager do the work for me.

As always, Vanguard’s fund expenses are low, which improves fund yields: The Vanguard Federal Money Market Fund has a yield of 0.72%. The T. Rowe Price Cash Reserves Fund, which Spratley manages, is up close to 0.66%. The yield of the Fidelity Money Market Fund is 0.60%. Virtually all major asset managers offer money market funds.

Once you start seeing them, you will find that the yields are increasing regularly.

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

when rates fall again
However, remember that these yields are still very low. They’re not keeping up with inflation, and if they eventually do, that’s probably not good news.

Imagine that in the not-too-distant future the Federal Reserve manages to lower the inflation rate to near its 2% target rate. To do so, however, is slowing the economy, perhaps even driving it into recession. This is no reason for celebration.

But as the recession clears, the Fed could start cutting rates, creating opportunities for nimble money market fund managers. They can extend their holding period so that the yield lags behind a fall in money market yields by up to two months. Then you could beat inflation, but only by a small amount. And with a slowing economy, you’ll have lots of other things to worry about.

For now, try to enjoy the spectacle of rising money market rates without falling prey to what American economist Irving Fisher calls the “money illusion.” Do not forget that in reality, you are losing money.

Money market fund yields are improving, yes, but as an investment, they remain a bad idea.