The Fed’s new zero-tolerance policy

John W. Schoen Senior producer • Profile • E-mail

For the first time in its history, the Federal Reserve has set a target for short term interest rates as low as zero percent. The moves signals that the central bank has entered a new phase in its campaign to revive a battered U.S. economy. Here's what the Fed is up to:

Q: What does it mean if interest rates go to zero? Does everyone get to borrow money for free?

No. Pushing the federal funds rate down to zero doesn’t mean everything comes with zero-percent financing. It means banks can now raise cash — for very short periods — without paying interest.

Think of the Fed's target as the wholesale price of money. Banks and other lenders will still charge more than zero interest when they lend it to you and me. That’s how banks make money. But borrowers with very good credit will be able to get a great deal on a short-term loan.

The problem is that with the economy shrinking, businesses cutting back and banks worried about getting their money back, lenders have become stingier about providing credit. To get the economy moving again, the Fed typically cuts the cost of money to encourage more borrowing.

Q: So that’s why the Fed cut its target interest rate to zero?

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Not exactly. Short-term interest rates already had fallen below the Fed’s latest 1 percent target before Tuesday's move cutting that target to a range of zero to 0.25 percent. The Fed normally achieves its target by buying and selling Treasury securities to move cash in or out of the financial system.

But short-term interest rates have been falling sharply since the financial markets went into a tailspin in September. With Tuesday’s announcement the Fed was essentially acknowledging that it can’t control interest rates any more.

Q: If the Fed isn’t controlling rates, how come they’ve fallen to zero?

In a full-blown global market panic, investors around the world have dumped other holdings — from stocks to corporate bonds — and stampeded into U.S. Treasury securities. That’s because, despite the turmoil in the U.S. economy and heavy borrowing by Uncle Sam, Treasury debt is still considered the safest place to stash cash.

Like all debt securities, the interest rate on Treasuries moves lower as demand pushes up the price.

Demand has been so strong, in fact, that at times the return on short-term Treasuries has gone negative — meaning investors are so afraid of the financial markets that they’re willing to lose a little money just to make sure they got most of it back.

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