Rates

Money Market Account

The past three years have seen money market investors and savers get clobbered by low interest rates. This is bad enough on its own, but add in rising inflation thanks to “QE2″ and it becomes downright dismal. The annual inflation rate is 3.6 percent, as measured by the Consumer Price Index, and it has held steady for the past three months. (1) With the Federal Funds Rate target set between zero and 0.25 percent, this implies a real interest rate for the economy of -3.35 percent. Savers and investors who have their money in cash or cash equivalents are losing it due to negative real rates.

Money market investors suffer from this environment because the value of the short-term debt securities is being slowly eaten away. Low interest rates and rising inflation are bad news for savers and conservative investors. The economy is stagnating, with the recent employment report released on September 2, 2011 showing no jobs were created in the month of August. (2) This, paradoxically, may hold good news for money market investors. The Federal Reserve announced its decision to hold interest rates down at record low levels for another two years on August 9. Investors and financial market participants are expecting the Federal Reserve to announce a new version of a trick not seen since the 1960s: Operation Twist. (3)

In 1961, the U.S. economy was in recession and interest rate arbitrage was in full swing. Under the postwar Bretton Woods system, the U.S. was obligated to redeem dollars held abroad for gold at the rate of $35 per ounce. Interest rate arbitrageurs were taking advantage of low short-term rates by exchanging dollars for gold and taking it to Europe. They would use the gold to buy higher-yielding assets and reap large profits. (4) The U.S. government and Federal Reserve came up with a plan to hold long-term rates low while pushing up short-term rates. The Federal Reserve sold short-term Treasury bills and bought long-term Treasury bonds.

The plan was never shown conclusively to work, since the total amount used was only $6.9 billion. Federal Reserve Chairman Ben Bernanke has spoken favorably of the scheme, leading to expectations he will try it again. If he does, and short-term interest rates rise, this will be a huge boon to money market investors. The money market uses short-term debt securities as collateral, including short-term Treasury bills. Higher short-term rates give savers and conservative investors a bigger return on their money.