What Bernanke's Plan Means for Money Market Rates

In early February, Federal Reserve chairman Ben Bernanke laid out his exit strategy for some of the Fed's extraordinary measures to stimulate the economy. Could his plan also be a roadmap to higher money market rates?

Where Money Market Rates Have Been...

As Bernanke unveiled his plans, rates on money market accounts were at 0.33%, according to the national average compiled by the FDIC. Money market rates have been mired at these low levels for several months. Part of this can be attributed to the weak economy, but much of the blame has to go to measures to stimulate that economy.

The Federal Reserve directly controls a number of very short-term interest rates used to manage liquidity within the banking system. These have traditionally been used by the Fed to fine-tune the economy. Lower interest rates tend to stimulate economic growth by making borrowing cheaper. Higher interest rates can be used to slow economic growth, which can be necessary to rein in inflation.

Because the rates the Fed directly controls only affect very short-term liquidity, their impact on interest rates in general is limited. Across most of the maturity spectrum, interest rates are determined by free trading via the bond market. However, last year the Fed took the unusual step of acting to influence even longer-term interest rates by buying massive amounts of bonds, including mortgage-backed securities.

The key target in this effort was mortgage rates, which responded by reaching all-time lows. Not only are lower mortgage rates an example of stimulating spending by making borrowing cheaper, but they act directly to shore up the housing market, which had been the source of much of the economy's trouble over the past couple years.

By and large, these measures seem to have worked. The economy is emerging from recession, the financial system is more stable, and even housing prices have firmed up a little. The jury is still out on whether any or all of these improvements will continue and generate sustained economic growth. What is clear, however, is that the innocent victims of all this have been depositors in money market accounts and other bank products, who have seen the rates they earn slashed to almost nothing.

...and Where They May Be Going

Bernanke's recent testimony made it clear that the Fed intended to boost short-term rates as soon as economic growth was firmly rooted. Already, the program to purchase mortgage-backed securities is set to expire in March, though the Fed reserves the option of continuing to buy mortgage-backed bonds beyond March if the economy falters.

If market interest rates are allowed to rise, money market account rates and other bank rates should soon follow suit. Note, however, that the real key here is not the Fed, but economic growth. The strength of the economy will dictate whether the Fed can take its thumb off of interest rates and let them rise to more natural levels.

The financial media and investment community are full of Fed-watchers--people who hang on Bernanke's every signal. To really anticipate what's going on, instead of watching the Fed, watch what the Fed is watching. Economic indicators, particularly employment, hold the key to when money market rates will rise again.