I'm asking a friend who's a bit more rigorous on the economics of this for a more complete answer.


The basic principle is this: to encourage (or discourage) spending, the US Federal Reserve Bank (and its equivalents in other countries or monetary unions) adjusts several interest rates at its control, key among them the inter-bank lending rate -- this is the rate at which banks are charged for loans made among themselves and the FRB. Effectively, it's their cost of money -- BofA runs a little short one night, they do a quick loan from the FRB to cover the underage. Banks' own rates (eg: the "prime lending rate") are based on some value on top of the Federal Reserve Rate. There's another measure which is the amount of money banks have to hold on their investments (it's a percentage of the total loan). There's periodic quibbling among bankers that this FRR crimps their style (it does), but the reason is that the extra few percentage points provide the leverage the FRB needs to manipulate money supply.

When you're looking at interest rates, you're concerned with three values -- two are given, the third falls out. There's nominal interest, inflation, and real interest. Nominal is the printed rate, say, 4.88% APR on an interest-bearing savings account. Inflation is just that -- the published inflation index, usually based on a consumer price index, more on this later. The real interest rate is the difference between the two. It's possible to have a negative real interest rate (though positive nominal) if nominal interest is below the real rate of inflation.

The tie to the monetary supply is this: if interest rates are reduced, banks can effectively loan more money because their holding reserve requirement is reduced. If I have $100, and my holding reserve is 10%, I can only lend a maximum of $1000. If my holding reserve is 5%, I can lend a maximum of $2000. To economists, this doubles the money supply. There's more money chasing more investment opportunities, and, eventually, bringing in more returns (there's an assumption that these investments bring in positive returns).

In hot economic times, you want to raise the effective real interest rate (shrink the money supply) to slow down investment. In slow economic times, you want to lower the effective real interest rate (grow the money supply) to increase investment. If inflation is high enough, you may have a negative real interest rate, but it's masked by the inflation rate.

Right now, we've got very low, and possibly negative, inflation. While the FRB's been lowering interest rates, the economy still hasn't responded. There are several discussions of why this is (high consumer debt, uncertainty, excess capacity, inventory, inertial, other issues), but the result is that the Fed's policy is in limp noodle stage. Pushing a spaghetti noodle when it's dry is fine, the cooked ones don't respond very well. The "liquidity crunch" in classic fiscal policy is where the Fed finds itself slammed against a nominal interest rate of zero. If you're to go below this, you're paying people to borrow money -- not just in real terms (which can happen), but in nominal ones. This is uncertain territory .

As for deflation itself, while it seems like a good thing (your dollar is worth more tomorrow if you just sit on it), there's a hazard with runaway deflation -- this is the circumstance by which more and more people defer more and more purchases because they can get a better deal by waiting. When this starts happening on a nationally significant scale, economic activity as a whole starts to slow down, and feeds itself (the inverse is called an inflationary spiral -- your dollar is worth less tomorrow, you're better spending it today, and too much money chases too few goods).

Back to that consumer price index (CPI). It's currently just barely into positive territory, and has been floating around 2% for most of the 1990s. However, the producer price index (prices faced by companies producing goods) has been flat or falling since about 1997. There is also a fairly widely held belief among economists that the CPI overstates inflation by 1-2%, due to substitution effects and the "market basket". CPI is based on the cost of a standard set of goods, and the proportions of purchases they comprise, to consumers. The problem is that in a real economy, if the price of bread goes up, I buy less of it (or substitute flour and make my own), meaning my basket selection varies with relative price movements. Every once in a while (several decades) the "market basket" is renormalized. However, the concensus is that it consistantly overstates real inflation. Which means we may have been in a flat to deflationary trend for up to several years.