The Tyranny of Low Money Market Rates
July 12, 2001

Sylvia blanched at the figures. Her money market fund at Fidelity was earning a return of 3.7%. With inflation running at 3.6%, her real interest rate came to a measly 0.1%. Zero-point-one! Good grief, that was practically zero! In fact, Sylvia frowned, it was even worse once she accounted for taxes. After federal and state taxes on her interest income were deducted, concluded a thoroughly displeased Sylvia, the nominal 3.7% return on her Fidelity money market account yielded a real, after-tax rate of return of -1.1%!

Jeepers, it was enough to drive a person to drink. Sylvia poured herself a cup of coffee and returned to her grim ruminations. She considered alternatives. Would other conservative investments, such as, say, certificates of deposit, do any better?

A one-year CD, noted Sylvia combing through the financial pages of the newspaper, offered only modestly higher rates. She would have to weigh the benefit of the marginal increase in return against the discomfort of tying up the principal for a whole year. With a money market account, access to her funds was always assured. And she could write checks on her account. Like a checking account at a bank, she thought. Except, she thought, furrowing her brow, the nominal interest rate at a bank checking account was already zero (or close to it). Ha, ha, she thought bleakly, at least there would be no taxes on zero interest income. But even this morbidly cheery thought faded when she realized that the inflation devil still had to be paid his due. A zero nominal return meant that her purchasing power would fall by 3.6% over the year.

How about bonds? Now, Sylvia knew, she was venturing into slightly inhospitable terrain. While bonds offered the promise of higher returns, they came with additional risk. Junk bonds were among the riskiest of all. If you bought these high-yielding securities from a corporation that then became bankrupt (a not uncommon occurrence in times of economic distress), you might lose your entire investment. Even government bonds, safe as they were, were not immune from risk. Their prices fluctuated daily, and if one sold a bond prior to maturity, there was no assurance that one would recoup the principal amount.

Finally, there were stocks. Ah yes, thought Sylvia taking a vigorous sip of coffee, the magnificent stock market! Let's see now, thought Sylvia as she scanned the financial pages again, how much had the Dow Jones Industrial Average fallen this year? There it was--Dow down 5% since Jan. 1. Broader market indices were harder hit: S&P 500 down 10%, Nasdaq a whopping 20%. Clearly, thought Sylvia, the stock market was no place for the faint of heart. And certainly not, she thought recalling her Finance lectures at St. Norbert College, a place for short-term investments.

Sylvia made up her mind. She would leave her retirement funds, most of which were invested in stocks, untouched--but funds required for more immediate purposes would be funnelled into her money market account and a smattering of CDs and bonds. She wan't enamored with the likely returns on her short-term investments, but she would have to grin and bear it.

But there was a silver lining to it, realized Sylvia. After all, if money market funds were paying less than 4%, overall interest rates were also probably low. Which, in turn, meant that interest rates on loans for, say, buying that new minivan, would be about... her pulse quickening, Sylvia turned to the newspaper again.