Deteriorating sidelined cash
What does a continued low Federal Funds target rate mean to your clients? If you have clients with sidelined cash, they may be locking in negative real yields (inflation greater than the interest earned on cash). For cash that’s been earmarked for immediate spending this may not be a problem, but for cash needed even a year or two out, this may be an issue.
It’s easy to ‘talk’ about loss of purchasing power, but maybe some of your clients would benefit from a concrete numerical example.
The future value (purchasing power) of a dollar amount of C today, t years into the future, can be computed:
where i is the real annual rate of return.
Calculating the real annual rate of return is easy; simply subtract the inflation rate from the rate of return.
What to use for our assumed inflation rate and cash rates? On April 25th, the Federal Open Market Committee (FOMC) released their latest Federal Funds target rate and decided to keep it at the 0-0.25% level we’ve seen since December 16, 2008.
More importantly, the FOMC continued to project interest rates to be “exceptionally low” until at least late 20141 while continuing to target a 2% inflation rate. The 1-3 month Treasury Bill rates are a good proxy for cash returns (what might be earned in a money market fund). The average of the last three years is 0.12%.2 So a real annual rate is 0.12%-2.0%, or -1.88%.
Let’s assume your client has $100,000 sitting in cash. The purchasing power of that $100,000 three years hence (assuming 2% inflation) is $94,465. Based on that, your client’s $100,000 today will only be worth $94,465 three years from now.
That’s not a small difference. There can be a ‘cost’ to your clients for being too safe. Is there an alternative? Possibly.
For clients unwilling to jump back into the equity markets just yet, perhaps they can afford to take on a little bit more risk in fixed income markets. Isn’t this the Fed’s original intent – encourage investors to select investments riskier than money market funds in order to help stimulate economic recovery?
It’s certainly worth a conversation.
1″Federal Reserve issues FOMC statement,” 2012 Monetary Policy Releases, Board of Governors of the Federal Reserve System, April 25, 2012
2Source: Barclays 1-3 Month Treasury Bill Index; 2009 (0.16), 2010 (0.13), 2011 (0.07)
The Barclays U.S. 1-3 Month Treasury Bill Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. In addition, the securities must be denominated in U.S. dollars and must be fixed rate and non convertible.