Isn’t the economy in really bad shape?

I know this is a ridiculous question, but I have to ask it because asking ridiculous questions is the only way I can really understand things that I just don't understand at all.

My question is about the Federal Reserve lowering interest rates: I have heard that when the Federal Reserve lowers interest rates what they are really doing is creating dollars that didn't exist before in the attempt to create the interest rate they are targeting. So here comes my ridiculous question: If that is what they are doing, then why can't interest rates go below zero? Why is it impossible that they can create so much money that we have an interest rate of -1%?
— Robert Bloomer, Durham, N.C.

One of the reasons we started writing this column was the belief that there are no ridiculous questions — only ridiculous answers. (Since then, we’ve occasionally been proven wrong.)

Yours, however, is not at all ridiculous. The question of “negative” rates comes up all the time. Your analysis of how the Fed targets rates is close: The “creation” of money comes from the Fed’s actions in the bond market. The Fed’s New York trading desk is the mechanism by which policy decisions are carried out through sales and repurchases of Treasury debt.

If the Fed buys Treasuries, it takes cash from its own account and pays the holder of the bonds (usually big “money center” banks), who then send that cash circulating throughout the economy. To raise rates, the Fed sells Treasuries, mopping up excess cash and tightening credit. There are other tools in the Fed’s arsenal, but these market actions are the most powerful and immediate. (And “money” is created by other means: Every time you use your credit card, in theory, you’re “creating” cash that wasn’t there before. That cash gets mopped up when you pay off the card, but if we all just charge more and more every month, we’re “creating” money.)

Interest rates don’t have to go to zero to produce the effect you describe: Borrowers look at the “real” cost of money when they decide whether or not to borrow.  The “real” rate is the stated rate minus inflation. That’s because inflation is burning a hole in the purchasing power of money while you’re paying it back. Since you repay with inflated dollars, you’re getting a break on the “real” cost of repayment. So If you borrow at 5 percent, and inflation is running 2 percent, you’re really only paying 3 percent in real (inflation-adjusted) dollars. So you can see that if inflation is running at nearly 4 percent, and overnight interest rates are at 3 percent, we’re actually in negative territory right now.

If the headline rate actually went to 0 percent, and inflation rose, you can see how money would get cheaper much faster. The problem is that as inflation rises, money also loses its purchasing power much faster, which destroys savings and investment. (That’s what we had in the 1970s.)

That’s the risk the Fed faces now: If it keeps rates too low, it risks losing control of inflation. Once that happens it’s extremely difficult — and painful — to get inflation back under control, as former presidents Nixon, Ford and Carter learned.

The real problem right now, however, is not the cost of money. Money is cheap enough; lenders are just too scared to lend. So they’re charging a lot more than they otherwise would. The reason they’re scared is that no one knows just how bad or widespread the damage has been from the housing/mortgage meltdown.

If you’re Bank of America and Citibank calls up and asks for a loan, you may be wondering in the back of your mind if Citibank has come clean with all the bad news about its loan losses. Accounting rules give you some leeway in rolling over bad debts. And the Fed seems happy to oblige. If these bad debts eventually blow up, you don’t want to be one of the parties on the list that is owed money.

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