What Causes a Decrease in Money Market Rates?

The Federal Reserve Act of 1913 created the U.S. Federal Reserve Bank with a mandate to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." The way the bank has complied with this mandate is through Federal Reserve monetary policy and Federal Reserve open market operations.

A booming economy tends to increase inflation because every consumer, bank and corporation borrows money. The more money borrowed, the more the nation's money supply grows. Inflation occurs when there is so much money available in the system that it overwhelms the available supply of goods to buy. Goods become more scarce compared with money, and prices rise.

The Fed must keep prices stable, so it adopts a restrictive monetary policy. This removes money from the system by raising interest rates and selling Treasury securities in the open market. It also removes money from the system by raising the requirements for the amount of money banks must hold in reserve to back any defaults as a result of their lending activities. The Fed raises rates by increasing the discount rate, which is the rate banks pay at the Fed discount window to borrow money to meet their higher reserve requirements.

If the banks are paying higher rates to back their lending, they pass on those rate increases to their customers in the form of higher rates on loans. Higher loan interest rates, in turn, slow the growth of the economy by making money more expensive, which also restricts the money supply. As loan rates rise, the interest rates on bonds, bills and notes increase to attract investors' money. This is when your money market fund pays high interest rates.

When the economy cools so much it begins to fall into recession, the Fed adopts an expansionary monetary policy. It lowers interest rates by lowering the discount rate and bank reserve requirements. Banks now have more money to lend because they don't have to keep so much in reserve, and they lend it at lower interest rates. Consumers and corporations start borrowing again, and this increases the supply of money in the system. Interest rates on all maturities decline because it is no longer so difficult to attract investors' money. This is what happens when your money market rates decline.

Short-term securities, those with maturities under one year, are called money markets because they are where consumers and corporations tend to keep their extra cash. Securities that mature in three-months or less are actually considered cash equivalents because they are highly liquid and very secure in terms of investment safety.

This element of safety is also why money pours into these securities from investors seeking safety for their money during times of crisis. When the Fed adopts an expansionary monetary policy, the first rates affected are the shortest ones. For example, between the Fed and uncertain times, money market rates dropped so low they were nearly imperceptible after the 2008 credit crisis.