The Fed’s new zero-tolerance policy

Q: Wait a minute: how can interest rates go “negative”? Doesn’t that mean the borrower gets paid interest instead of the lender? How can that happen?

That’s what happens when so many investors want to buy debt from the Treasury — in effect, lend it money — that they’re willing to take a little less when the debt matures.

Besides, when you’re talking about the real cost of borrowing, you can't just look at the nominal interest rate — the sticker price, if you will. Instead, you have to factor in the future spending power of the money you’re borrowing.

In normal circumstances, the spending power of cash is gradually eroded by inflation. So if you’re paying 4 percent interest on a loan when inflation is running at 2 percent, your true borrowing cost is only 2 percent — because you’re paying off the debt with money that has lost 2 percent of its spending power.

Last year, when inflation was running at 4 percent, and the Fed targeted short-term rates at 5.25 percent, that meant the real cost of short-term borrowing for banks was about 1.25 percent. Since then, the Fed has been cutting rates and, more recently, inflation has been coming down. That means the normal impact of rate cuts — spurring lending and getting the economy growing — has been less pronounced.

Q: But the government reported Tuesday that prices actually fell in November. What effect does that have on rates?

It means that it'll still cost you something to borrow, even if the sticker price of short-term borrowing fall to to zero. That's what happens when inflation — a steady rise in prices — turns to deflation and prices keep falling.

With the threat of inflation gone for the moment, the Fed is now worried that deflation may take hold. Deflation turns everything upside down; instead of losing spending power, your money is worth more as prices fall. If that keeps up, people postpone purchases to get a better price; companies sell less stuff and have to cut production and lay off workers, those workers can’t buy stuff, and the cycle continues.

It also makes it more expensive to borrow because you’re paying back your debt with dollars that are worth more than they were when you borrowed them. If prices continue falling at 1.7 percent — and interest rates are at zero — the true cost of borrowing is 1.7 percent. That works against the Fed’s efforts to make borrowing cheaper and get the economy moving again.

Q: So if it can’t cut rates below zero, what does the Fed do now?

It shifts gears. Plan B involves flooding the economy with trillions of dollars in cash, which the Fed began doing in September. Through a variety of special “facilities” the Fed has been buying up debt that no one else wants to buy. It’s already bought more than $1 trillion worth and says it plans to buy more.

This is called “quantitative easing.” It means the Fed makes money easier to get by providing it in vast quantities. The hope is that now that battered banks have been pulling back from the aggressive lending that got us into this mess, all this money sloshing around in the system will find its way into the hands of businesses and consumers that are having trouble getting loans.

Q: Is this going to work?

The honest answer: No one knows. The last time anything like this was tried, Japan’s central bank cut its short-term target rate to zero for five years — from 2001 to 2006 — to fight a nasty bout of deflation that was touched off in the 1990s by a collapse in real estate prices.

The prolonged recession in Japan has been called the Lost Decade. Most economists believe the Fed’s aggressive policy to flood the U.S. economy with money will help get the economy back on track by sometime next year. There’s a significant lag effect in any Fed move.

But we won’t know for some time whether the zero interest rate policy — combined with quantitative easing — will be enough to do the trick.

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