Will the Fed action have an economic impact?
The most interesting question of the day is whether the Fed's aggressive action will actually have any impact on the economy. On the surface, one would expect positive psychology to develop in the financial markets. While the equity market did close higher on Wednesday, it closed down on Thursday and Friday. Equity investors aren't sure that the Fed cut will help profits.

When the Fed reduces its target rate, one's first thought is that mortgage rates will decline. In fact, whether mortgage rates decline or not depends on Treasury yields, not the fed funds rate. While the yield on the 10-year Treasury note has come down in the past week, yields on the 2-year and 5-year notes have not. This could mean that mortgage rates are not going to exceed the lows already seen in this cycle.

When the fed funds rate declines, one also assumes that banks will reduce their prime rate. Banks did lower the prime rate on Thursday, from 4.75 percent to 4.25 percent. They weren't in any hurry to lower their rates on Wednesday after the Fed announcement. Historically, banks typically have announced their rate changes immediately following a Fed change. (And you could be sure that the moment that the Fed announces an increase, banks will be raising their prime rate rather quickly.) Home equity loans are usually tied to the bank prime rate, but some banks have a lid on these rates, holding the home equity loan rate above the bank prime rate. Consequently, depending on your personal bank, your home equity loan rate might not change with the latest drop in the federal funds rate target.

Many credit cards are tied to the prime rate. Credit card rates have not seen major declines in the past couple of years. Here too, banks maintain floors as to how low rates can go for their customers. Delinquency rates have been a problem this year, thus many credit card companies don't want to reduce their rates even if borrowing rates have declined. It is possible that credit card companies will continue to offer special deals (lower rates for a limited time) to their preferred customers.

Auto companies continue to offer zero percent financing to entice customers. The reduced fed funds rate target will help keep these offers on track for a while longer. (It will be quite difficult for car companies to wean customers off these special deals when the economic recovery becomes more pronounced.)

The lower federal funds rate target has a negative side as well. Lower rates are good for those consumers who need a jumpstart to buy large ticket items. However, the lower rates do not stimulate savings. Rates on CDs are low across the board, making it less appealing to tie up money for a long period of time.

The consumer has played a major role in this recovery already. In fact, the consumer helped boost growth even during the recession. It shouldn't be up to the consumer alone to get the economy rolling. Lower borrowing costs could help companies who are making capital spending decisions. The capital-spending boom of the 1990s led to the bust cycle that is currently underway. There is no question, though, that lower borrowing costs could make the decision to spend by corporations more palatable. In fact, spending on equipment and software expanded in both the second and third quarters of this year. In addition, corporate cash flow (analogous to consumer disposable income) has posted year-over-year gains for the past four quarters (through the second quarter of 2002, the last data available).

The majority of economists are noting that it will take about 6 to 9 months before the impact of the 50 basis point rate cut will be felt on the economy. One question is whether the Fed is pushing on a string? For the rate impact to be real, mortgage rates will need to come down from current levels, home equity loan rates will need to decline and credit card rates will have to decrease. The Fed has done its part - now it is up to bankers to reduce the appropriate rates to spur the consumer. It will be up to corporations to increase their capital spending in order for the economy to keep growing.

Productivity: onward and upward
Nonfarm productivity expanded at a 4 percent rate in the third quarter after growing at an anemic 1.7 percent rate in the second quarter. There is no question that the faster rate of productivity was due to the stronger pace of GDP growth in the third quarter over the second. The same number of workers were able to produce more goods. Productivity gains are always viewed as a good sign because it means that workers' wages can increase without creating inflationary pressures. Unfortunately, it also means that companies, able to produce more with less, will be in no hurry to hire new staff. In this environment job growth will remain subpar. The chart below shows productivity growth on a year-over-year basis. The year-over-year figures tend to be more consistent and reliable over time than quarter-to-quarter changes. In fact, nonfarm productivity is up 5.3 percent from a year ago, a bit better than the yearly gain of 4.4 percent in the first quarter and 4.9 percent in the second quarter.

Unit labor costs rose at a 0.8 percent rate in the third quarter relative to the second quarter after posting a 2.2 percent gain in the previous period. In the manufacturing sector, unit labor costs continued to drop like a rock. Data are not available for non-manufacturing but given the overall rise it appears the Labor Department assumed a labor-cost increase for the sector. Unit labor costs fell 2 percent in the third quarter relative to a year ago (we prefer to look at year-over-year changes since they tend to be less variable and more consistent than quarter-to-quarter). This decline was somewhat less than the two previous quarters, but is nonetheless the fourth straight. With lower unit labor costs, corporate profit margins are improved.

Factory orders rise in Q3, not in September
Factory orders fell 2.3 percent in September with a plunge in durable goods orders offset slightly by a rise in nondurable goods orders. The third-quarter picture was somewhat better as total new orders, as well as nondefense capital goods orders, managed to rise compared to the second-quarter. High tech goods orders were down slightly over the three-month period. Considering the sharp declines since the third quarter of 2000, the gains we see in the graph below are rather pathetic. Hopefully, the Fed's most recent rate cut will help spur manufacturing activity in the fourth quarter.