In a succession of cuts, the Fed reduced the short-term interest rates to near zero in late 2008 (WSJ 12/17/2008). If the Fed’s intention was to revive the economy from the housing bust, it has not succeeded. Bank lending to small businesses remained anemic. Consumer credit has been tightened. And unemployment rates have remained high at about 10%.

The Fed is powerless to lower the interest rates further unless it is willing to drive interest rates to below zero. Negative interest rates mean that a given amount of bank deposits will shrink absolutely over time. So it pays bank depositors to spend their money sooner than later. But savers could always keep their money under their mattress and “earn” zero nominal interest instead of negative nominal interest. In other words, the US economy is in the vice of a classic liquidity trap.

Banks are reluctant to lend because they need to conserve cash to back up bad loans made earlier. In other words, they are mired in a debt trap. And they are afraid new loans may turn bad in the uncertain economic environment. If the yield curve is very flat (see The Yield Curve), the longer-term interest rates may not be high enough to justify the risk of making longer-term new loans. But if the yield curve is steep, then it is safer simply to borrow short from the central bank to buy safe government bonds (WSJ 12/17/2009). In Japan, the flat yield curve has discouraged lending. In the US, the steep yield curve has encouraged the purchase of government bonds rather than lending. For example, the yield spread between a 10-year Treasury bond and a 1-year Treasury bill was more than 3 percentage points (NY Times 4/15/2010). So the low short-term interest rates pursued by the Fed ended up fattening the bottom line of the shaky banks rather than stimulating lending.

If cheap money ends up lowering the cost of government deficit financing, monetary policy has in effect become a back-door fiscal policy. And if budget deficit financing leads to higher inflation rates than the interest rates, real interest rates could be driven down to negative territories. Indeed, the $787 billion stimulus package may not be big enough to significantly contribute to economic growth, but the positive inflation rates in 2010 are enough to drive the real short-term interest rates to below zero (usinflationcalculator.com). Some economists are seriously suggesting the Fed’s targeting a higher inflation rate to jump start the economy. That will surely drive the real short- term interest rates deeper into the negative territories.

But with the US public debt/GDP ratio projected to be over 100% in the next few years, any aggressive economic stimulus may threaten the credit rating of Treasury bonds and increase their yield costs.