How low can you go? If you're Ben Bernanke, the answer will remain zero for at least the next two years. The Federal Reserve Board Chairman (by some measures, the most powerful man in the world) recently announced that he plans to keep interest rates negligible through 2014. Bernanke thus estimates a long-term goal of 2% inflation for the near future. How will that impact you?

SEE: What Investors Should Know About Interest Rates

Low Rates
For starters, it means money will continue to be artificially cheap. It's been artificially cheap for three years now, the rationalization behind the low rates being that they make it easier for people to borrow money, invest it in expensive things of lasting value that require long-term financing (e.g. homes), and thus watch the economy rebound that much more quickly.

However, it hasn't quite worked that way, largely because unemployment remains at generational highs, and it's hard to take advantage of low rates when you don't have much income.

If you're trying to save, well, there isn't much incentive to put your money in a standard interest-bearing certificate of deposit (CD) or money market account when the payouts are so low. There are ultimately only two things you can do with a dollar - spend it now or defer spending it (the latter also known as saving and/or investing). Low interest rates, and by extension, low inflation, encourage people to spend those dollars faster.

"Inflation" is a word with a negative connotation, which makes some sense. When your money's purchasing power decreases, that's always going to be bad, isn't it? If $1 today becomes worth 90-something cents next year, then taken to the extreme that could ultimately mean carrying wheelbarrows of bills around just so you can buy everyday grocery items. (That's not a metaphor, by the way. It happened in post-World War I Germany and in Zimbabwe as recently as three years ago.)

A little inflation isn't necessarily negative (accent on "little"). If that sounds counterintuitive - that your money gradually losing value can't possibly be beneficial - give it a few more paragraphs.

Contrast inflation with a zero change in price levels (or with inflation's rarely seen antimatter counterpart, deflation.) Yes, under the latter scenario your dollar buys as much as or more than it did before; but without at least a little inflation, lenders and borrowers would have to change their behavior so much that it could mean the end of banking.

No Inflation?
Over the last 20 years or so, three-year CD rates have averaged a little above 5%. Will your bank offer you a 5% CD if inflation is at zero? Keep in mind that inflation has averaged about 3.3% annually over the last century, and that a posted interest rate is essentially the inflation rate added to the real, constant-dollar interest rate. That nominal 5% then becomes a real interest rate of 5% without inflation; no inflation means the nominal rate and the de facto rate are identical.

If prices stayed the same from year to year, no bank would offer you a rate anywhere near as generous as 5% on a CD. (As proof of this, three-year CDs are currently going for around 1.4%.) If lenders started offering 5% three-year CDs today, they'd have to lend money out at even higher rates in order to stay in business. Few people are going to borrow money from a bank if they have to pay it back at a real interest rate of 6 or 7%, especially today. The higher the (real) interest rate gets, the less chance the borrower has of being able to pay the loan back, which means that no one borrows money at all. Businesses can't grow and the economy stagnates, ultimately lowering GDP.

So why wouldn't a lender just lower the nominal interest rat, and charge the same real interest rate it always did? Because nominal interest rates can't get much lower than they already are. One-year CD rates are barely 1% right now. If they fell 100 basis points, there'd be no appreciable difference between putting your money in a bank and hiding it in an empty tomato can in the pantry.

The Bottom Line
There's no formally defined level of "normal" inflation, but it makes sense for us to let that 3.3% number serve as one. With a normal level of inflation, it's more likely that borrowers and lenders can find that happy equilibrium. At a federally mandated 2%, we're still uncomfortably close to stagnation. Many experts think that raising inflation by a point or two could help people who are looking to maintain a constant income from their investments.

Regardless of whatever money professionals and a sense of justice would dictate the Fed should do, the Chairman has spoken. At the very least, if we can be somewhat certain that we'll have 2% inflation for the next couple of years, then we should be able to make investment and saving decisions accordingly.

Related Articles
  1. Investing

    Is it Time to “Buy” Inflation?

    Based on recent data from the Treasury-Inflation Protected Securities (TIPS) market, it would seem that most investors aren’t worried about inflation.
  2. Economics

    Where Would the Dow Be Without Fed Intervention?

    What would the Dow look like without the accommodative monetary policies the Federal Reserve has implemented since the financial crisis?
  3. Mutual Funds & ETFs

    How Interest Rates Affect Mutual Funds

    Find out how changing interest rates impact mutual funds, including bond and money market funds, and how higher rates can discourage investors.
  4. Economics

    How the Fed Fund Rate Hikes Affect the US Dollar

    Learn about the effects the federal funds rate on the U.S. dollar. Understand what happens when the Federal Reserve increases interest rates.
  5. Investing

    What is the Fiscal Year-End?

    It’s an important consideration for determining taxes, expenses and other financial matters.
  6. Economics

    10 Wealthiest States in the United States

    A review of the 10 richest states in America as ranked by median household income.
  7. Investing

    What a Fed Delay Means for the ECB & BoJ

    The Fed’s continued delay has repercussions for more than just the U.S. economy and markets. The ECB and the BoJ may support the case for stocks in Europe.
  8. Economics

    Understanding Income Inequality

    Income inequality refers to the uneven distribution of income across a single economy.
  9. Economics

    Who is a Hawk?

    In the economic sense of the word, a hawk is someone who believes high interest rates should be maintained to keep inflation low.
  10. Investing Basics

    Explaining Fixed Exchange Rates

    A government using a fixed exchange rate has linked the value of its currency to the value of another country’s currency, or the price of gold.
  1. Who decides to print money in Russia?

    The Central Bank of the Russian Federation (CBRF), like its peers in most countries, is the governmental entity responsible ... Read Full Answer >>
  2. Who decides to print money in Canada?

    In Canada, new money comes from two places: the Bank of Canada (BOC) and chartered banks such as the Toronto Dominion Bank ... Read Full Answer >>
  3. Who decides when to print money in India?

    The Reserve Bank of India, or RBI, manages currency in India. The bank's additional responsibilities include regulating the ... Read Full Answer >>
  4. Is Japan an emerging market economy?

    Japan is not an emerging market economy. Emerging market economies are characterized by low per capita incomes, poor infrastructure ... Read Full Answer >>
  5. What are the best ways to sell an annuity?

    The best ways to sell an annuity are to locate buyers from insurance agents or companies that specialize in connecting buyers ... Read Full Answer >>
  6. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!