Paper on Zero Bound and MMFs
Harvard University professors Marco Di Maggio and Marcin Kacperczyk posted a paper entitled, "The unintended consequences of the zero lower bound policy for the money market funds industry." It says, "The zero lower bound policy for nominal interest rates was implemented to stimulate sluggish economic growth and boost employment. This column explores whether this policy had unintended effects on the money market fund industry. Traditionally enjoying relatively low and safe returns, money market funds could respond to the low interest rate environment by either exiting the market or changing product offerings and accepting higher portfolio risk. The results show evidence of both, and point to an important but neglected channel for monetary policy transmission." The piece states, "In the aftermath of the Global Crisis of 2007-2008, the US Federal Reserve took an unprecedented decision to lower short-term nominal interest rates to zero, a policy commonly known as the zero lower bound policy. This initial action was followed by a sequence of announcements providing guidance that the short-term rate would stay near zero for a longer period. While several economists have argued that the Fed's policy exerted a positive impact on the US economy by stimulating sluggish economic growth and boosting employment, some critics pointed out that the policy might have also produced undesired consequences, such as inflation in asset prices, or ill-suited incentives to chase higher yields (e.g. Maddaloni and Peydro 2011 and Jimenez et al. 2014, among others). One important part of the financial system that could be significantly impacted by the long-term low interest rates is the money market fund (MMF) industry." It continues, "Traditionally, MMFs used to offer relatively low returns for the provision of safety. While this idea has been somewhat shattered by the collapse of the Reserve Primary Fund and the run on MMFs in September 2008 (e.g. Kacperczyk and Schnabl 2013, Chernenko and Sunderam 2014, Strahan and Tanyeri 2015), until then, MMFs had provided investors positive returns, even after paying fees. The consequence of the unprecedented change in interest rates to levels close to zero has been that returns on traditional money market instruments -- such as Treasuries, repos, or deposits -- declined to similarly low levels. Therefore, any fund investing in these assets was likely to produce negative net-of-fees nominal returns to their investors. It has thus become obvious that such business models cannot be sustained for too long, as money would flow out of funds with negative returns. Such a dire situation has posed a dilemma for money funds. On the one hand, they could accept the situation and keep their risk profiles unchanged. This, however, would force them to first reduce or even waive their fees, and in the end, if the low rates persisted, to exit the market. On the other hand, funds could change their product offerings by shifting their risk into securities with higher interest rates, thus accepting higher risk in their portfolios, an idea referred to as reaching for yield. Increasing fund risk would boost returns and investor flows (e.g. Christoffersen 2001), and would likely prevent funds from exiting the market. The cost of increasing risk would be a higher chance of being run on in the event of distress in the money market industry.” The paper concludes, "Overall, our results highlight an important channel for transmission of monetary policy that has been completely overlooked by the academic literature, but one that is extremely relevant for practitioners and policymakers, especially in the current regime of unusually low interest rates worldwide. This message resonates well with the August 2009 Fitch report about US MMFs that states: "Over the longer term, more conservative portfolio composition, combined with the current low interest rate environment, may result in fund closures, fund consolidation, and/or a resurgent appetite for credit and liquidity risk.""
