As the economy hangs in the balance, money market rates hover near zero. What will happen next and how will it affect money market rates?
Broadly speaking, the two biggest economic influences on bank rates are Gross Domestic Product (GDP) and inflation. Right now, both are in low gear, where the numbers are positive, but just barely. Imagining two extremes for each of these influences - growth or stagnation for GDP, and low or high inflation - yields four likely types of economic outcomes. Understanding these outcomes, and how they affect bank rates in general, should help you follow economic developments in the context of their impact on your money market accounts and other deposits.
- Low inflation, stagnant GDP growth. This is a good place to start because it describes the current situation. Inflation has been very mild - up just 1.1 percent in recent months. GDP, meanwhile, has grown for four consecutive quarters, but the pace has slowed since the end of 2009. Outcome: You already know how this scenario turns out, because you've been living it for the past year. Low economic demand leaves banks with little incentive to attract deposits, so money market rates are low. Inflation isn't a problem, so the best money market rates can stay ahead of it, but just barely.
- High inflation, stagnant GDP growth. If you think the current situation is bad, just imagine if growth remained stagnant but inflation started to rise. This could happen if growth in large developing countries sparked commodity inflation, or even if a rise in what are now extremely low labor costs occured. Outcome: This would be the worst outcome for money market rates. Bank rates themselves would be slow to rise because banks still wouldn't have much incentive to attract deposits, and those low bank rates would rapidly lose ground to inflation.
- High inflation, high GDP growth. Inflation would remain a problem under this scenario, because it not only erodes wealth, but it also destabilizes the economy by creating uncertainty about prices. Outcome: This is far from an ideal scenario, but if GDP growth perked up, you'd at least see money market rates rise more rapidly, giving you a fighting chance of staying ahead of inflation.
- Low inflation, high GDP growth. It sounds too good to be true, but this is essentially what the U.S. enjoyed in the late 1990s, when it was referred to as the "nirvana economy," or the "Goldilocks economy" (because everything was just right). Outcome: Under this scenario, interest rates are able to maintain a strong edge over inflation. This type of economy is difficult to achieve, and even tougher to sustain. Too much of a good thing brings about the kind of complacency about risk that leads to the boom-and-bust scenarios we've seen over the past decade or so. Still, this is the ideal environment for deposit accounts, and most investments in general while it lasts.
For the time being, a continuation of the first scenario seems likely. Then, it remains a question of whether growth or inflation will start to move first. It's definitely worth keeping a close eye on since your investments are tied up with the outcome.