In a world of 2 percent inflation, an interest rate of 7 percent has quite a different economic meaning than it would if inflation were running at 5 percent.

The difference between the interest rate and the inflation rate is known as the real interest rate. Economists say that for both investors and borrowers it's the real interest rate that matters in terms of economic impact.

A real interest rate of 5 percent -- a nominal rate of 7 percent, minus inflation of 2 percent -- is a much better deal for an investor than the 3 percent real rate that results when the nominal interest rate is the same 7 percent but inflation has moved up to 5 percent. Similarly, the higher the real interest rate, the more burdensome it is for a borrower to repay a debt.

For such reasons, many Federal Reserve officials, including Chairman Alan Greenspan, keep close watch on the level of the real federal funds rate, which is shown in the chart at the right.

The nominal federal funds rate -- for which the central bank sets a target as part of its effort to keep the economy growing and inflation low -- is the interest rate financial institutions charge one another on overnight loans. Different officials use different inflation measures to come up with a real rate, but a common one is the change over the preceding 12 months in the "core" consumer price index, which excludes volatile food and energy prices.

The chart shows how that version of the real federal funds rate can fluctuate even when the Fed doesn't change its target for the nominal rate -- as it did on June 30 when it raised it by a quarter-percentage point, to 5 percent from 4.75 percent.

At the beginning of 1997, for example, the real funds rate was running about 2.7 percent. In March of that year, the Fed raised its funds target to 5.5 percent from 5.25 percent. Since the inflation rate didn't change immediately, the real funds rate blipped upward to reflect the Fed's action.

The Fed didn't raise its target again during 1997 -- indeed, it didn't change until last fall when the central bank cut rates three times to counter the effect of a worldwide financial crisis. Nevertheless, as the chart shows, the real federal funds rate kept rising moderately because the inflation rate gradually declined.

Even though the Fed wasn't taking any overt action, Greenspan and many of his colleagues watching the real funds rate regarded its upward movement as the equivalent of further tightening as far as its restraining effect on economic activity was concerned.

That restraining effect occurs because the real funds rate, as opposed to the inflation, component of interest rates is the true cost of borrowing money. As long as there is some inflation, debts are repaid in dollars that are worth less than when they were borrowed and are thus easier to repay. When inflation falls and the interest rate doesn't, a debtor gets less help in that sense.

Asked at a congressional hearing about the increasing real funds rate in 1997, Greenspan said the Fed was fully aware of what had happened and the fact that the Fed let it happen was "not inadvertent." In other words, monetary policy became more restrictive over time, and that was just fine with Fed policymakers at a time of booming economic growth.

The Fed, which raises interest rates when necessary but would prefer never to have to, was perfectly happy that the decline in inflation was, in effect, doing its work for it.

The real federal funds rate reached roughly 3.3 percent in the fall of 1997 and stayed at about that level until August 1998, when a default by the Russian government on a part of its debt triggered a world financial crisis.

Over the next three months, the Fed cut its funds rate target three times, by a total of three-quarters of a percentage point, and the real funds rate fell accordingly. But the 12-month change in the core CPI also rose somewhat, and that added to the size of the drop in the real funds rate.

The upward blip shown on the chart for early 1999 was the result of a renewed decline in the inflation rate. With the 12-month change in the core CPI likely to be about the same this month as in June, the Fed's June 30 increase in the nominal funds rate will probably push the real funds rate up to about 2.9 percent.

Thus, the real funds rate will remain below where it was before last fall's financial crisis when economic growth was clipping along at about a 4 percent pace. Now, after the latest Fed action, growth doesn't appear to be all that much slower, while the real funds rate probably is still about 0.4 percentage points lower than it was before the crisis.

Is that appropriate? With the economy behaving in some unprecedented ways -- such as having an inflation-dampening surge in labor productivity growth years after an expansion began rather than at the beginning -- it's hard for Fed officials to be sure.

Many analysts expect at least one more rate increase before the year is out, with Greenspan and his colleagues concluding that monetary policy is still too generous if the goal is a modestly slower rate of economic growth.

Some Fed officials undoubtedly would prefer an even higher real federal funds rate, but none has in mind levels such as those seen around 1984 and 1989, when the nation's inflation rate was much higher than it is today.

And no one wants to see economic growth as slow as it was at the beginning of 1993, when problems in the banking system caused the Fed to lower the nominal federal funds rate to 3 percent, a rate so low that the real funds rate turned negative.