On Dec. 11, the Federal Open Market Committee of the Federal Reserve meets to discuss monetary policy. The conventional wisdom among Fed-watchers is that it will cut the federal funds interest rate by another 25 basis points (0.25 percent), reducing it from 2 percent to 1.75 percent, its lowest level since 1961.
Just one year ago, the fed funds rate stood at 6.5 percent. This is the rate that banks charge each other on overnight loans. Hence, it represents the basic cost of funds for the entire banking sector. The spread between the fed funds rate and what banks can loan money at is their profit margin. With home mortgages at 6.5 percent, corporate bonds at 6 percent and the prime rate at 5 percent, there is clearly profit to be made.
Theoretically, competition should drive market interest rates down when the fed funds rate is cut. Lower interest rates should increase borrowing, investment and consumption, thereby stimulating economic growth.
Unfortunately, monetary policy is not quite so simple, as Japan's experience demonstrates. There, the central bank has cut the equivalent of the fed funds rate virtually to zero. Yet borrowing has not been stimulated, and the economy has been mired in recession for many years.
One explanation for the Japanese experience is that lower interest rates have not been accompanied by an increase in monetary liquidity. In effect, monetary policy remains tight despite the low nominal interest rates, putting deflationary pressure on the economy. With the price level falling in Japan, even very low market interest rates can be high in real terms.
Economists believe that it is the real interest rate -- the nominal rate minus the inflation rate -- that determines borrowing and lending. If the inflation rate is high enough, as it was in the late 1970s, then it is quite possible for the real interest rate to be negative. In effect, you borrow $1 and pay back only 90 cents. All a borrower has to do is make sure the borrowed funds are invested in an asset, such as real estate, that can be depended upon to at least keep up with the inflation rate.
As long as inflation continues, going deeper and deeper into debt makes economic sense. The problem, of course, is that inflation doesn't continue for long. Eventually, various political and economic pressures force the central bank to tighten monetary policy. At this point, the house of cards built on debt collapses as asset values fall. The result is massive bankruptcies and liquidation of uneconomic investments.
The flip side to inflation is deflation -- falling rather than rising prices. Deflation has the reverse effect of inflation on interest rates, causing the real rate to rise above the market rate. Thus if the price level is falling 3 percent per year and the nominal interest rate is 2 percent, the real interest rate is 5 percent. In this case, even a zero percent market rate, as Japan has, would still yield a real interest rate of 3 percent -- equal to the deflation rate.
Of course, the steeper the deflation rate, the higher real interest rates become. Since market interest rates can never fall below zero, they cannot adjust enough to compensate. (Nominal rates cannot fall below zero because anyone with cash can, in effect, earn interest simply by stuffing their money in a mattress.) Thus, deflation severely discourages borrowing and lending. It also discourages spending, as consumers wait for prices to fall further before buying.
Technically, what happens is that the velocity of money falls during a deflation. That is the number of times a given dollar is spent. It is the money supply times velocity that really determines the impact of monetary policy on the economy. During inflations, velocity rises as people try to spend money quickly before it falls further in value. During deflations, it is the reverse, with velocity falling as people hold on to their money as long as possible before spending it.
One theory about why lower interest rates have not stimulated borrowing or spending is because of deflation. Economist David Gitlitz of TrendMacro.com points out that, despite recent increases, the Dow Jones Spot Commodities Index is down 12 percent so far this year, and the Commodity Research Bureau Futures Index is down 16 percent. Gold, oil and even car prices are all falling. This deflationary pressure is sharply reducing velocity, negating the effects of the Fed's interest rate cuts.
Although some economists are starting to predict an early recovery next year, those who believe the U.S. economy is suffering from deflation are much more sanguine. Until the Fed adds enough liquidity to the economy to stop commodity prices from falling, they believe, a sustained recovery cannot begin.