By John W. Schoen Senior producer
msnbc.com
updated 12/17/2008 9:06:41 AM ET 2008-12-17T14:06:41

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?

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.

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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.

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.

(The Associated Press contributed.)

Video: Has the Fed run out of options?

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