Another Hurdle That's Tripping Up Business

With pricing power weak, borrowing is just too costly

On the face of it, the cost of borrowing for corporations is dirt cheap. Interest rates for corporate bonds have fallen to their lowest level since 1968. The most creditworthy companies paid an average of 6.3% on their bonds in the third quarter of 2002, according to the Federal Reserve, down from 7.1% in the first quarter of 2001.

But even as rates have fallen, corporate pricing power has deteriorated even faster. As a result, even low interest rates can be onerous, since companies have to make their debt payments from a flat, or even falling, stream of revenue. For corporations, therein lies one of the biggest dangers of a near-deflationary economy.

In fact, after adjusting for the lack of pricing power, the true cost of borrowing for companies has risen by almost a full percentage point since early 2001. That's a key reason why U.S. businesses have been unwilling to invest, despite Federal Reserve Chairman Alan Greenspan's 11 rate cuts since then.

Hard to believe? Traditionally, so-called real interest rates are defined as market interest rates minus core consumer inflation, which excludes volatile food and energy prices. By this measure, borrowing for companies has become cheaper.

But the traditional measure is misleading. When it comes to assessing the actual burden of corporate borrowing, it's more relevant to look at how fast companies can raise their own prices. And so-called corporate inflation has fallen much more steeply than consumer inflation, which has been boosted by such noncorporate items as housing.

In the first quarter of 2001, the typical business was able to boost its prices at a 2% rate, according to the Bureau of Labor Statistics. Subtracting that from the average 7% bond rate means that the "real" interest rate faced by businesses was about 5%. Since then, the interest rate for corporations has dropped by almost a percentage point. But businesses are now able to raise their prices only at a 0.4% rate. The result: Real interest rates for the most creditworthy of corporate borrowers have risen to 5.9%--a higher rate than they paid on average during the boom years of the 1990s.

By contrast, consumers have seen their real interest rates on home loans edge down over the same period. That's true when measured in the usual way--by subtracting the rate of core consumer inflation from the actual interest rates paid. But it's also true when the nominal rates are adjusted to reflect the rate at which wages are rising. Since the beginning of the recession in early 2001, both measures show that inflation has come down by 0.5 percentage points, while average 30-year fixed mortgage rates have declined by 0.7 percentage points. So real mortgage rates have fallen from 3.3% to 3.1%.

As a result, the gap between the cost of capital for companies and consumers has grown to about three percentage points, the widest it has been in the past two decades. That large gap goes a long way toward explaining why consumers have been so much more free-spending than corporations.

By Michael J. Mandel in New York

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