Money Market Vs. Interest Rates

Markets move when the Federal Reserve announces a change in interest rate policy.

Markets move when the Federal Reserve announces a change in interest rate policy.

Any investment that matures in under one year is considered a cash equivalent, so the market for those investments is called the money market. People who put their money in money market mutual funds or bank money market accounts don't care that the interest they pay is low. Those accounts are for accumulating money in a safer place than a mattress. When there is no crisis, interest rates on these accounts directly reflect Federal Reserve monetary policy.

Safety

When your money market mutual fund or your bank money market account is paying really low interest rates — the kind that are so low they almost don't exist — it means there are a lot of people looking for a safe, short-maturity place to keep their money. This happens when there is a lot of economic uncertainty. During times of extreme economic or political crisis, certain money market investments have actually paid negative interest — meaning the investor was glad to pay to have a safe place for his money.

Federal Reserve

Rates on money market investments are also affected by Federal Reserve monetary policy. When the Fed wants to boost the country out of a recession, it lowers the discount rate, which is the rate banks pay to borrow money from the Fed discount window. When banks can borrow money at very low rates from the Fed, they don't want to pay much for money borrowed from their depositors, so they lower the rates on their certificates of deposit and other deposit accounts. Most of the securities in the money market are originated by commercial and investment banks. The Fed also puts money into the country's money supply by purchasing Treasury securities in the bond market. This is called Fed open market operations. Because the Fed buys such a huge volume of Treasuries in its open market operations, interest rates in the market tend to drop.

Market Interest Rates

In the bond market, longer maturity bonds trade based on supply and demand. If investors are concerned about the safety of their money, the interest rates on long maturities, such as 30-year bonds, rise to attract investors. Higher interest offsets the risk of buying a long-maturity investment. When the Fed comes in to lower interest rates, it also buys long bonds, so rates are lowered even on the very longest maturity Treasuries. Corporate bond rates also fall because their rates are based on the rates paid by Treasury bonds of similar maturities. The Fed wants interest rates lower so it is less expensive for companies to borrow money in the bond market to fund their operations and purchases of facilities and equipment. When this happens, the companies also hire new employees and those employees spend their salaries buying consumer items like food, clothing, automobiles and homes, so the recession turns into an economic boom.

Higher Interest Rates

When the economy is strong, there is a lot of demand for money. Your money market accounts and funds pay their highest rates at this time because the banks are anxious to attract money to lend out. Companies that are borrowing by issuing bonds have to pay higher interest rates to attract investors because everyone is borrowing money, even consumers are borrowing. This leads to inflation, so the Fed raises interest rates even higher to make borrowing expensive. This is when you see your money fund rates begin to decline. Investors are taking money out of short maturities and putting it in long maturities to lock in the high rates of return for as long as possible. As companies and consumers stop borrowing because rates are too high, the economy starts to cool down. Boom times turn toward recession and it starts all over again. The Fed moves to lower interest rates to spur the economy out of recession.

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