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Money markets adjust quickly to inflation [ClearOnMoney]
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Money markets adjust quickly to inflation

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Commentary

Money markets adjust quickly to inflation

20 Dec 2010 by Jim Fickett.

Putting your savings in short-term money-market instruments, such as T-bills, might not be the best investment choice under high inflation, yet performance is better than you might expect.

John Hussman's weekly market commentary makes an interesting point today.

short-term Treasury securities have historically been quite good inflation hedges. This is because short-term interest rates quickly adjust to reflect prevailing inflation rates, so unless you get a period of persistently negative real interest rates, the strategy of staying relatively liquid in interest-bearing securities has been fairly effective. It is certainly true that non-interest bearing cash is ineffective in preserving real purchasing power during a period of inflation, but the same is not true for short-dated money market securities.

Let's look at this quantitatively.

Calling any rate of inflation over 3% “high”, the big period of high inflation in the US ran from August 1966 to January 1996 (see US CPI). To make calculations simple, look at 1-year T-bills and just use whole year periods from January 1966 to January 1996. Imagine that you had $100 at the beginning of 1966, put it into 1-year T-bills and rolled the results over each succeeding January. The graph below shows how much money you would have at each January first (blue line), and where price levels would be at the same time (red line), as measured by the consumer price index, scaled to January 1966 = 100.

(T-bill yields from the Federal Reserve. CPI from the BLS.)

As you can see, as inflation increases from 1966 to 1980, funds in T-bills just barely keep pace. But then, as inflation decreases, the T-bill yield does not drop as fast, and the funds in T-bills pull well ahead of prices.

There are several caveats to this analysis:

  • This does not take taxes into account – staying even is not good enough, since the nominal increases, really due to a shrinking currency, are treated as profit by the IRS
  • The CPI underestimates the cost of living; I do not think this is as big a problem as some people do, but it is an issue
  • If, in the worst case, we were to see hyperinflation in this country (unlikely but not inconceivable), all bets are off on the value of government paper
  • The Fed can manipulate interest rates in unpredictable ways

There are probably better strategies that staying in T-bills or money-market funds, but it is a valid and important point that short-term instruments do adjust quickly to inflation, and probably perform better than most people would expect.