Money Market Rates Look Better In the Current Financial Context

As of early july money market account rates were averaging 1.38%. There was a time when you might have turned up your nose at that number. Now, taken in the context of a deflationary environment, that number isn't so bad. Compared to what's been going on elsewhere in the financial markets, it looks even better, and when you add the extra you can get through active shopping, money market rates look better still.

This is, after all, an era in which everyone has to change their financial assumptions, so a readjustment of assumptions about money market rates would be in order.

Money Market Rates and Inflation/Deflation

Financial returns are often classified into categories of nominal returns and real returns. The nominal return is just what you see on paper--5% is 5%, or in the case of recent money market rates, 1.38% is 1.38%. The real return is the return over and above inflation. This is important, because it measures the actual change in purchasing power to the investor. In other words, that 5% nominal return is also 5% in real terms if there has been no inflation. However, if inflation was 5% over the same time period, the real return is zero--the investor hasn't really gotten anywhere.

What makes the current environment a little different is that consumer prices have been going down, not up. In other words, we have deflation rather than inflation. According to the most recently-available 12 month figures, deflation has reached the 1.0% mark (or inflation was -1.0%, depending on how you want to think about it). If deflation continues at that rate over the next year, the 1.38% nominal money market yield would actually be worth 2.40% in real terms.

To think of it differently, if inflation were running at a more normal rate of about 4%, it would take a 6.5% nominal return to produce a 2.40% real return. If you think of today's 1.38% money market rates as the equivalent of 6.5% under more normal inflationary conditions, they start to look much more appealing.

Other Alternatives

The 1.38% yield on money market accounts also takes on added significance when compared with what's going on in the stock market. In a high-growth environment, 1.38% would have been easy to pass up. However, over the past decade, the S&P 500 has been losing money at a rate of 2.22% per year. Even for a growth investor, earning 1.38% per year would have been a better alternative than losing 2.22% every year, and of course, money market rates were actually higher for most of that period. That doesn't mean that stocks wont regain their growth characteristics in the future and have an appropriate place in a long-term portfolio, but what it does mean that in an era when positive returns have been scarce, money market returns are all the more appealing.

Meanwhile, short-term bonds are yielding 0.13%. Long-term bonds are yielding more, but don't have comparable liquidity and stability characteristics.

The Rewards of Active Rate Shopping

Even at an average rate of 1.38%, money market yield aren't bad given the broader financial environment. When you add on the extra percentage point or so you can get by shopping for the best money market rates, they start looking better all the time.

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