The news stories on the Federal Reserve's expected move today to cut short-term interest rates will say that the central bank pushed the cost of money below 4% for the first time since 1994.
But by one important measure, the cost of money is near zero--arguably putting the United States in the same camp as Japan, where borrowing costs are nil.
The real rate of interest--nominal interest rates minus the rate of inflation--in theory ought to be as important, or even more important, than the nominal rate.
Because inflation devalues money over time, dollars borrowed today will effectively cost a borrower less when paying them back later, assuming there is some inflation. Thus, the lower the real, or after-inflation, cost of money, the greater the incentive for people and companies to borrow. Or so says classic economic theory.
Yet many experts disagree on the extent to which borrowing activity--and economic activity--depend on real interest rates. In fact, the last few years have lent more credence to the view that few potential borrowers consciously pay much attention to real rates.
Economists also disagree on how much Fed Chairman Alan Greenspan and his peers are focused on real rates versus nominal rates.
Nonetheless, "it is the true measure of how tight, or easy, they are" with credit, said Scott Grannis, economist at Western Asset Management in Pasadena.
With the Fed's five half-point rate cuts this year in its target for the federal funds rate, the overnight loan rate among banks, the nominal fed funds rate stood at 4% this morning before policymakers' meeting. Another cut of at least a quarter-point is expected today.
The goal of this year's Fed cuts has been to shore up the decelerating economy by making it easier for consumers and businesses to borrow and spend. On a nominal basis, the fed funds rate has dropped from 6.5% to 4% this year.
But the real cost of money appears to be much cheaper. After subtracting an inflation rate that ran at a year-over-year rate averaging about 3.5% in the first five months--mainly because of soaring energy costs--the real fed funds rate is a mere 0.5%.
By that measure, the real interest rate hasn't been as low since 1992-93, when the Fed kept rates at generational lows for nearly two years amid sluggish economic growth and widespread fears about a then-fragile U.S. banking system.
Adjusted for inflation, then, the Fed would appear already to be giving money away almost free--not unlike Japan's situation in recent years, as that nation's central bank has kept interest rates near zero to try to ignite the economy.
(In Japan's case, however, a deflationary trend in prices, with nominal rates near zero, means real interest rates are actually negative, economists note.)
Some Wall Street pros say the Fed is doing exactly what is necessary in quickly slashing the real fed funds rate to near zero this year.
"Often, but not always, the central bank has had to reduce the real fed funds rate to zero to regenerate growth," said Jeffrey Applegate, investment strategist at brokerage Lehman Bros. in New York.
But measuring real interest rates is inherently problematic, economists say. You can know what real rates are and have been, but from the viewpoint of someone borrowing or lending today, you can only guess what the real cost of money will be in the future because inflation is an unknown.
Greenspan himself has insisted that inflation, other than in energy, isn't a problem for the economy. If the jump in the inflation rate this year is temporary, and inflation falls back to a 1% or 2% rate in coming years, then the real fed funds rate still is well above zero. That could mean the Fed will perceive that it can cut rates much further if the economy warrants.
On the other hand, if inflation continues to rise, then the real fed funds rate already is negative. That would be a boon for many borrowers--but a disaster for lenders, if they have allowed borrowers to lock in decent nominal rates.
It also would be a disaster for the Fed because it would mean the central bank grossly miscalculated the strength of inflationary pressures in the economy.
Yet many experts doubt that borrowers, for now, are paying much mind to what real rates are or what they could be under various inflation scenarios.
James Grant, editor of Grant's Interest Rates Observer newsletter in New York, argues that, for better or worse, "the world conducts its business in nominal dollars" rather than in real dollars.
Corporate bond issuance has rocketed this year, but it was strong in the late '90s as well. Homeowners have been rushing to refinance their mortgages, but most people are far more likely to think about the after-tax cost of their loans than the after-inflation cost, financial planners say.
Meanwhile, even high-risk companies that can't get particularly low rates still are interested in borrowing in the junk-bond market today, if they think they can find investors to buy their securities.
Though the fed funds rate, the economy's benchmark short-term rate, is near zero, real long-term rates aren't cheap for many companies. For example, an index of 100 junk bonds tracked by KDP Investment Advisors sports a yield of 11.12%. Subtract 3.5% inflation, and the real rate is about 7.6% for junk borrowers.
By contrast, when the KDP junk yield was 9.5% at the end of 1996, inflation for that year was 3.2%. The real interest cost for junk then was 6.3%.
"At the end of the day, [the decision to borrow] mostly depends on whether you think your business is good or not," said Edward Yardeni, economist at Deutsche Banc Alex. Brown in New York.
What's more, he noted, companies and consumers believe they have plenty of flexibility to refinance later if they lock in what turns out to be a lousy rate. At least, that has been true as inflation has fallen during the last two decades, dragging nominal interest rates down as well.
"I doubt that people look at the real cost of money when they make the decision to borrow," Grannis agreed. If their outlook is positive, and they believe they can afford it, the nominal rate is what matters, he said.
Still, he noted: "The real cost of borrowing is what will either make them or break them in the end."
Tom Petruno can be reached at email@example.com.