In August, money market fund rates fell to their lowest level since they became alternative saving instruments for the public. The current average yield on money market funds for the week ending August 4 was 0.08 percent. Almost a quarter of the 1,180 funds had no yield that week. The average yield was equal to an $800 annual return on a million dollar deposit. Approximately $3.5 trillion is invested in money market funds.
Money market and Federal funds rates have fallen to historical lows. According to Standard & Poor's, these rates are more than 95 percent correlated. Critical questions for investors going forward are when will these rates climb from their abysmally low levels, how fast will they ascend ,and to what rate. More specifically, what will happen to these rates over the next two years?
As a benchmark, consider what happened the last time the Federal Reserve started the cycle of Fed funds rate increases and how that process unfolded. On June 25, 2003, the Federal Reserve lowered the funds rate to 1 percent, the low point in the last down cycle. It took the Fed over 22 months and 8 rate increases before the funds rate reached 3 percent. Then-Chair Alan Greenspan has been repeatedly criticized for holding rates at such a low level for such an extended period of time. Notwithstanding that criticism, a 2 percent increase in rates from their current near zero level is likely to take longer this time.
We have come through a very frightening and challenging economic cycle. The damage done and fear engendered in this Great Recession is far greater than during the dot-com recession. In their wake, the Fed will make rate increases cautiously. The Fed will likely take more time than in the previous cycle before making its first rate increase and will likely move more cautiously in making subsequent increases. A combination of complex and interrelated factors makes this caution especially likely this time around.
There is considerable speculation among eminent economists that the economy may dip down again before it has achieved a sustainable recovery - the so-called double dip. Ben Bernanke has been reappointed Chairman of the Fed. Bernanke is an expert on the Great Depression, having authored a leading text on the subject. Bernanke is well aware that in the Great Depression there was a second dip in 1937. High profile economist Nouriel Roubini has stated that there is a "big risk" of a double dip this time around and that risk is growing. The concern is not simply that the GDP will slip back into negative territory but, alternatively, that the growth rate could fall back merely to an uncomfortably low level. While the risk of increasing rates too fast is always a concern of the Fed as it begins tightening, the perceived risk of a double dip is far greater now than in the aftermath of the dot-com recession. The result will be slow progress in beginning and executing a cycle of rate increases.
In addition to concerns about a double-dip recession, most economists expect the recovery from this Great Recession to be unusually tepid. If they are right, there will be little pressure in the near term to raise rates in order to avoid inflation or another potential bubble. Inflation for 2009 is running flat to slightly negative with little reason to expect much change in the coming months.
The Fed's rate cutting arsenal is now empty. The funds rate is effectively zero. In the long run, the Fed will want to restock its rate cutting arsenal so it has the ammunition needed to assist in a recovery from a future recession. At present, however, the Fed will be especially cautious in the early stages of the rate raising cycle because it would have extremely limited rate cutting ammunition if a double dip occurred. For instance, if the economy tipped back into decline when the Funds rate was at 1.5 percent, little would be available in the way of rate relief to aid in an economic rescue.
Avoiding a violent reaction is another reason that the Fed will move gingerly. Former Fed Governor Laurence Meyer in his book "A Term at The Fed" said that changes in the funds rate occasionally provoke "a violent reaction." This is especially true at tipping points in rate cycles. When the Fed increases rates for the first time after an extended period of rate decreases, or decreases rates after an extended period of increases, it has uniformly ushered in a new cycle of rate increases or decreases. The immediate reaction to such a shift is hard to predict and manage. But the Fed will try to manage the reaction. It will not risk an adverse reaction until the economy has sufficient buffer to absorb such a shock.
Raising interest rates and tightening credit always have adverse economic effects. There are some special reasons for concern at present. The failure of the financial system was at the heart of this Great Recession. The Fed came to the rescue with extremely low borrowing costs for commercial banks. That policy contributed to bank stabilization. Raising those costs will take away some of the banks' indirect subsidy and potentially endanger their new found stability. Adjustable rate loans are another concern. Home owners with adjustable rate mortgages were major contributors to the collapse of the housing bubble. Their rates went up steeply as the Fed funds rate climbed from 1 percent in 2003 to 5.25 percent in June, 2006. Many defaulted on their loans. The subsequent drop in the Funds rate to zero has provided adjustable rate borrowers very significant relief. If the Funds rate was to go up again, and as a result, loans were to reset at higher levels, trouble is sure to follow. 13 percent of home loans are currently delinquent or in foreclosure. The Fed will be reluctant to undertake interest rate hikes that will materially increase that number.
Unemployment is a core factor in the Fed's decisions on the Funds rate. Most economists predict that unemployment will continue to increase well into 2010. From both an economic and political perspective, the Fed will be highly reluctant to increase rates if the unemployment rate crosses the double digit line to 10 percent or more. Most economists and the White House Office of Management and Budget expect the unemployment rate to exceed 10% in the next few months.
Putting these factors together, the Fed will not make its first rate increase until it is confident that the economy is clearly in lift off. It is likely (more than 50 percent probable) that the Fed will first increase the funds rate in mid-2010. The first rate increase is almost certain to be a conservative .25 percent move. After the start of the last up cycle under Greenspan, each of the Fed's subsequent increases for the entire cycle was .25 percent - a slow, steady path. Bernanke's Fed will likely follow this game plan, only hesitating if growth slows or the economy goes into reverse. The Fed will probably not undertake bold .50 percent or .75 percent increases. As a result, the Fed funds rate and money market rates are likely to first reach the 2 percent range approximately two years hence. If the double dip feared by some economists takes place, that timetable could be extended.
For the investor, the bottom line is that money market funds are likely to pay very low rates for the next two years. This will impact the investment mix for individual investors and the market as a whole.