How Inflation May Change Where You Put Your Cash (Published 2022) (2024)

The stock market hasn’t provided much joy, bonds have been a source of considerable pain and inflation is troubling.

But at last there is a glimmer of good news for people who need a place to park their cash: Money market mutual funds are finally beginning to pay a little interest.

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

But now that the Federal Reserve has begun to increase the short-term interest rates it controls directly, money market fund yields that are available to consumers have also started to rise — and they will continue their climb as long as the Fed continues to increase short-term rates.

“You can expect money market rates to keep rising for a while,” said Doug Spratley, who heads the cash management team at T. Rowe Price. “And they will be rising fairly rapidly.”

Don’t get too excited just yet. This isn’t a return to the early 1980s, when money market rates soared above 15 percent, along with the rate of inflation. The yield on the average big money market fund is still only about 0.6 percent, said Peter G. Crane, the president of Crane Data of Westborough, Mass., which monitors money market funds.

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

The latest Consumer Price Index numbers released on Friday showed inflation running at an 8.6 percent annual rate in May, creating an enormous gap between inflation and money market yields. That’s not good for your personal wealth, to say the least. To the contrary, it indicates that your real rate of return, adjusted for inflation, is deeply negative. In other words, the longer you keep your spare cash in a money market fund, the less purchasing power you will have.

The role of the Fed

Money market yields 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 one month.

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

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

But the Fed has been raising other interest rates as well, including one with a dismal name: the reverse repurchase agreement, a.k.a. the reverse repo rate.

That rate stands at 0.80 percent but was close to the zero bound for months. Money market mutual funds receive that rate for funds held by the Fed overnight, so it functions as a rough floor on yields.

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

As I wrote when interest rates fell to nearly zero in 2020, the operating expenses of money market funds exceeded the income they brought in. That meant, theoretically, that the funds could have resorted to paying negative yields 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 didn’t happen in the United States. Fund companies granted expense waivers — effectively, subsidies — to keep the funds in business.

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

A place for cash

As a practical matter, in the current unsettled markets, many people need good places to keep their short-term cash. In the past, I noted that several options — like bank accounts and Treasury bills — seemed reasonable. Now I would add money market funds to that list, with some qualifications.

Be aware that, yields aside, money market funds ran into some safety problems in the last two financial crises. Since then, they have been subjected to tighter regulatory scrutiny and to a series of reforms.

Many funds now hold only U.S. government securities, and all are required to hold only high-quality debt instruments. All are intended to avoid fluctuations in value, though they have come under strain before and could well do so again. In any case, money market funds are safer than bond or stock mutual funds or exchange-traded funds.

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

“At this point, I think they’re as safe as just about anything,” he said, but added that bank accounts with government insurance “have a slight safety edge.” Still, he said, if we are ever “in a situation where money funds are losing deep value, you will have a lot of other problems to worry about, like finding your hip waders 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 major financial crisis, it is quite possible that they could run into problems again, but the government has always stepped in to fix them.

There are other options for holding short-term money safely. Briefly put, they include U.S. government I bonds, which yield an amazing 9.62 percent, a rate that is reset 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 most pay is very low. A survey by Bankrate.com found that the average savings account yield in the United States was just 0.07 percent. Some online bank accounts have higher yields; in some cases, they are around 1 percent. Short-term bank certificates of deposits, Treasury bills and high-quality short-term corporate bonds are also available. All these rates are rising.

The yields paid by money market funds at the moment are below those of Treasury bills and corporate bonds or commercial paper, but with rates fluctuating, the funds have a great advantage. The fund manager can swap in higher-interest Treasury bills or commercial paper as they become available. I’m not willing to spend the 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 improves fund yields: The Vanguard Federal Money Market Fund has a yield of 0.72 percent. The T. Rowe Price Cash Reserves Fund, which Mr. 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 yields are rising regularly.

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

When rates fall again

Remember, though, that these yields are still extremely low. They aren’t keeping 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 2 percent target rate. To do this, though, it is slowing the economy, perhaps even tipping it into a recession. That’s no cause for celebration.

But as soon as a slowdown is evident, the Fed is likely to start cutting rates, creating an opportunity for nimble money market fund managers. They can extend the duration of their holdings so that yields lag the decline in money market yields by up to two months. You could then be beating inflation, but only by a small amount. And with a slowing economy, you will 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 the American economist Irving Fisher called “the money illusion.” Don’t forget that in real terms, you are losing money.

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