I have always been fascinated by the hidden mechanics of finance—the silent gears and pulleys that turn behind the curtain of everyday markets. Few relationships are more critical, yet more overlooked, than the one between the central bank’s primary tool and the savings vehicle millions of Americans rely on for stability. In my years of analyzing balance sheets and advising clients on liquidity management, I have seen firsthand how a change of a mere quarter of a percentage point can ripple through the economy, reshaping the yield landscape for ordinary savers and colossal institutions alike. This is not an abstract monetary theory; it is a direct line from a conference room in Washington, D.C., to the interest you earn on your emergency fund. Today, I want to unpack the precise mechanism of how the bank rate, specifically the federal funds rate, governs the performance of money market mutual funds (MMMFs). We will explore the history, the math, the strategy, and the future of this fundamental connection.
Table of Contents
Section 1: Defining the Actors – The Bank Rate and the Money Market Fund
To understand their relationship, we must first be precise about what each entity is. The common terminology can be misleading, so I will clarify.
The “Bank Rate”: It’s Not What You Think
When people say “bank rate,” they often conflate several concepts. In the United States, the pivotal rate is the federal funds rate. This is the interest rate at which depository institutions (like banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. It is not a rate the Federal Reserve (Fed) charges banks directly for loans—that is the discount rate. The Fed does not “set” the federal funds rate like a dictator; rather, it announces a target range and then uses open market operations to guide the market rate to that target.
I think of the federal funds rate as the foundational anchor for all short-term interest rates in the US. It is the cost of the most basic, risk-free, immediate loan in the financial system. Every other short-term rate—for Treasury bills, commercial paper, repurchase agreements, and, crucially, bank deposits—is priced as a spread above this anchor. The Fed adjusts this target to either stimulate a sluggish economy (by lowering rates, making borrowing cheaper) or to cool down an overheating one (by raising rates, making borrowing more expensive).
The Money Market Mutual Fund: A Cash Management Vessel
A money market mutual fund is a type of mutual fund that invests in high-quality, short-term debt instruments. Its primary objectives are the preservation of capital and the provision of liquidity, with yield being a secondary concern. Think of it as a pool of money from thousands of investors that is then used to buy a diversified portfolio of ultra-short-term IOUs from governments, banks, and highly-rated corporations.
The Securities and Exchange Commission (SEC) regulates these funds under Rule 2a-7, which imposes strict quality, maturity, diversity, and liquidity requirements on their portfolios. This is why they are considered exceptionally safe, though it is crucial to remember they are not FDIC-insured like a bank deposit. There are several types of MMMFs, but the main categories are:
- Government Funds: Invest primarily in U.S. Treasury securities and agency debt (e.g., Fannie Mae).
- Prime Funds: Invest in corporate debt (commercial paper), certificates of deposit (CDs) from banks, and repurchase agreements.
- Tax-Exempt Funds: Invest in short-term municipal debt.
The key takeaway is that a money market fund’s income, and thus the yield it can pay to its shareholders, comes entirely from the interest earned on this portfolio of short-term securities.
Section 2: The Direct Transmission Mechanism – How a Rate Change Flows into Your Yield
This is where the connection becomes clear. The securities in a money market fund’s portfolio are all short-term, with weighted average maturities (WAM) mandated to be 60 days or less. This means the portfolio is constantly turning over. As older securities mature, the fund’s managers must reinvest the proceeds into new securities.
Now, consider what happens when the Federal Open Market Committee (FOMC) raises the target federal funds rate. Almost immediately, banks will raise the rates they charge each other for overnight loans. To attract and retain deposits, they will also raise the rates they offer on certificates of deposit (CDs). Corporations, needing to fund their operations, will issue new commercial paper at these new, higher rates. The U.S. Treasury will auction new Treasury bills that reflect the new interest rate environment.
Therefore, when a money market fund manager goes to reinvest the cash from a maturing 0.05% T-bill, they are now able to buy a new T-bill yielding, for example, 0.30%. This process happens across the entire portfolio. The fund’s yield does not jump overnight; it glides upward as the portfolio gradually reinvests at higher rates. The speed of this adjustment is a function of the fund’s WAM. A fund with a very short WAM (say, 20 days) will see its yield rise much faster than a fund with a WAM near the 60-day limit.
The reverse is equally true. When the Fed cuts rates, the fund’s yield will glide downward as it is forced to reinvest maturing securities into new, lower-yielding instruments.
Let’s illustrate this with a simplified example. Assume a Prime MMMF has a portfolio with a constant WAM of 30 days.
Scenario: Fed hikes rates by 0.25% (25 basis points).
- Day 0 (Before Hike): The fund’s 7-day yield is 0.50%. Approximately 1/30th of its portfolio matures each day.
- Day 1: The Fed announces the hike. Newly issued 30-day commercial paper now yields 0.75% (up from 0.50%).
- Day 1 – 30: Each day, the fund reinvests the maturing portion of its portfolio into new paper yielding ~0.75%.
- Day 31: The entire portfolio has now turned over. The fund’s yield should be very close to the new market rate of 0.75%.
The calculation for the yield an investor sees is based on the income earned by the fund over a period, minus its expenses, divided by the total assets. The formula for the 7-day yield is:
\text{7-Day Yield} = \frac{(\text{7-Day Income} - \text{7-Day Expenses})}{\text{Average Net Assets}} \times \frac{365}{7}The “\times \frac{365}{7}” annualizes the figure, allowing for easy comparison between funds. The “Income” in the numerator is directly a function of the interest rates on the underlying securities, which are directly tied to the federal funds rate.
Section 3: A Historical Perspective – Lessons from the Zero Lower Bound and Beyond
We cannot fully appreciate this relationship without looking at recent history. The period following the 2008 financial crisis provides a powerful case study.
In December 2008, the FOMC lowered the target federal funds rate to a range of 0% to 0.25%—the so-called “Zero Lower Bound.” It remained there for seven years. During this time, the yields on Treasury bills and high-quality commercial paper were also near zero. This presented an existential problem for money market funds.
Their expense ratios—the costs of managing the fund—often exceeded the meager interest income the portfolio could generate. To prevent yields from turning negative (which would mean charging investors for holding their cash), fund sponsors waived millions of dollars in fees. This was unsustainable for some. The near-zero environment also led to the SEC’s significant 2014 reforms, which introduced liquidity fees and redemption gates for prime funds to prevent another event like the “breaking of the buck” by the Reserve Primary Fund in 2008.
The Fed’s rate normalization process starting in 2015 and the rapid hiking cycle from 2017-2019 vividly demonstrated the transmission mechanism. I watched fund yields climb steadily from near zero to over 2.00%, providing a meaningful return on cash for the first time in a decade. Then, in 2020, the COVID-19 pandemic hit, and the Fed slashed rates back to zero. Once again, MMMF yields collapsed within weeks, mirroring the action in the federal funds futures market.
This chart illustrates the powerful correlation:
Table 1: Federal Funds Rate vs. Average MMMF Yield (Selected Periods)
| Period | Fed Funds Target (Upper Bound) | Avg. Prime MMMF 7-Day Yield | Notes |
|---|---|---|---|
| Dec 2008 | 0.25% | 0.10% | Post-crisis cuts to ZLB |
| Dec 2015 | 0.50% | 0.25% | First hike in 7 years |
| Dec 2018 | 2.50% | 2.25% | Peak of hiking cycle |
| May 2020 | 0.25% | 0.30% | Post-COVID cuts |
| Dec 2023 | 5.50% | 5.25% | Peak of post-2022 cycle |
The data shows a near-perfect pass-through, with the MMMF yield typically sitting just below the federal funds rate due to fund management expenses.
Section 4: The Investor’s Calculus – Choosing Between Banks and Funds in a Rising Rate Environment
A critical question I am often asked is: “Why would I use a money market fund instead of just putting my cash in a high-yield savings account?” The answer lies in the speed of adjustment and the structure of the banking system.
Banks use deposits primarily to fund longer-term loans (e.g., mortgages, business loans). These loans have fixed rates for long periods. When the Fed raises rates quickly, a bank’s cost of funding (the interest it pays on deposits) can rise faster than the income from its existing loan book, squeezing its net interest margin. Therefore, banks have an incentive to be sluggish in raising deposit rates for their customers. They will only raise them as much as necessary to prevent deposits from fleeing to competitors.
A money market fund, however, has no such structural lag. Its portfolio is entirely short-term, so its income resets almost immediately to higher market rates. It must then pass this income on to shareholders to remain competitive. This is why, especially at the beginning of a Fed tightening cycle, money market fund yields will often rise faster and higher than the savings account rates at most traditional banks.
Let’s model a decision with \text{\$100,000} in cash.
Option A: High-Yield Savings Account
- Initial Rate: 0.50%
- Assumed rate increase: 0.10% per month for 3 months after a Fed hike, then stabilizes.
Option B: Prime Money Market Fund
- Initial Rate: 0.50%
- Assumed rate increase: Full 0.25% pass-through within one month.
We can project the cumulative interest earned over six months:
\text{Interest} = \sum_{m=1}^{6} \left( \text{\$100,000} \times \frac{\text{Rate}_m}{12} \right)Table 2: Cumulative Interest Comparison (\text{\$100,000} Principal)
| Month | Fed Funds | Savings Acct Rate | Savings Interest | MMMF Rate | MMMF Interest |
|---|---|---|---|---|---|
| 1 | 0.50% | 0.50% | \text{\$41.67} | 0.50% | \text{\$41.67} |
| 2 | 0.75% | 0.60% | \text{\$50.00} | 0.75% | \text{\$62.50} |
| 3 | 0.75% | 0.70% | \text{\$58.33} | 0.75% | \text{\$62.50} |
| 4 | 0.75% | 0.80% | \text{\$66.67} | 0.75% | \text{\$62.50} |
| 5 | 1.00% | 0.80% | \text{\$66.67} | 1.00% | \text{\$83.33} |
| 6 | 1.00% | 0.80% | \text{\$66.67} | 1.00% | \text{\$83.33} |
| Total | \text{\$350.00} | \text{\$395.83} |
This simplified model shows the MMMF generating approximately 13% more interest due to its more immediate response to the first rate hike. The difference can be even more pronounced in a volatile, fast-rising rate environment like we saw in 2022-2023.
Section 5: Risks and Considerations – It’s Not a Risk-Free Paradise
While I utilize money market funds extensively for my own and my clients’ liquidity needs, I never confuse them with actual risk-free assets like FDIC-insured bank accounts. The relationship with the bank rate also introduces specific risks.
- Interest Rate Risk (Minimal but Not Zero): With a WAM under 60 days, the price sensitivity of a MMMF to interest rate changes is negligible. However, if a fund’s WAM is longer, a sudden, sharp rise in rates could cause the net asset value (NAV) to dip slightly below \text{\$1.00}/latex. The 2014 reforms were designed to make this even less likely.
- Credit Risk: This is the risk that an issuer of commercial paper or a CD defaults. Rule 2a-7 mitigates this by restricting investments to the highest-quality securities, but the 2008 failure of Lehman Brothers, which had issued commercial paper held by many funds, shows the risk is non-zero. Government funds, which hold Treasuries, have virtually no credit risk.
- Liquidity Risk: This is the risk that a fund might not have enough cash on hand to meet redemption requests, potentially triggering the liquidity fees and gates mentioned earlier. This is a tail risk, but it became a real concern in March 2020 during the "dash for cash" at the onset of the pandemic, prompting the Fed to intervene.
- Expense Ratio Drag: The fund's yield is always net of expenses. A fund with a high expense ratio will consistently underperform one with a low ratio, even if they hold identical securities. This is a crucial factor for investors to compare.
Section 6: The Future of the Relationship – Digital Currencies and a New Paradigm
The mechanical relationship between the federal funds rate and MMMF yields is immutable. However, the landscape in which this relationship operates is evolving. The rise of fintech and the potential introduction of a Central Bank Digital Currency (CBDC) could introduce new competitors.
A US CBDC could theoretically offer every citizen and business a direct digital wallet at the Federal Reserve, paying an interest rate directly tied to the policy rate. This would create a truly risk-free asset that could compete directly with both bank deposits and money market funds, potentially disintermediating both. While this is a long-term possibility and faces significant political and practical hurdles, it is a factor I monitor closely.
For now, the money market fund remains a highly efficient vessel for transmitting the Fed's monetary policy directly to investors. It is a testament to the sophistication and liquidity of the American short-term credit markets.
Conclusion: Mastering the Rhythm of Cash
Understanding the symbiotic link between the federal funds rate and your money market fund yield is more than an academic exercise; it is a practical skill for cash management. It allows you to anticipate the movement of your cash returns, to make informed choices between savings products, and to truly understand the Fed's impact on your personal balance sheet.
I make it a habit to check the FOMC meeting calendar. In the weeks following a expected rate change, I know to watch the yield on my funds, observing the elegant mechanical process of reinvestment at work. It provides a sense of control and clarity in the often-chaotic world of finance. In the end, your cash is not sitting idly; it is participating in the vast and rhythmic dance of the global money markets, led by the steady, deliberate baton of the central bank. By understanding the steps of this dance, you can ensure your money is always moving in time.
