Diving below zero

The typical way Central Banks give a helping hand to the economy is by lowering interest rates. By making it cheaper to borrow they can encourage spending and thereby create growth. Today countries such as America and the United Kingdom find themselves in a situation of near zero nominal interest rates. From this one could easily draw the conclusion that interest rates can't be used to stimulate demand further.

This is of course true if we think of interest rates in a nominal sense. But in a real sense, that is when taking inflation in to account there is no such limit. Let's say that nominal interest rates are at 0% while inflation is at 2%, then the real interest rate would be a negative 2%. Borrowers would then in effect get paid to borrow. Since Central Banks hold the power over the printing press they are free to set inflation at whatever level they choose. The higher they push inflation the cheaper borrowing will become. This can be done purchasing pretty much anything of value and paying with fresh money.

Quantitative easing would be a good example of this practice. Even if more attention is given to its power to channel private investment over from public debt to the stock market and they way that it lowers the currency. By in effect increasing the money supply it also drives real interest rates further and thereby has the same positive effect on the economy as a lowering of the prime interest rate.

If the actions of central banks are constrained by anything it is their fear of inflation. Not by any practical limit on their power to shape the business cycle.