The heat is off the Federal Reserve to raise short-term interest rates.

The government reported Friday that producer prices, a key barometer of wholesale inflation, were unchanged in May after a surprisingly strong jump in April.

And retail sales, which rose more than 1% in April, increased a scant 0.1% in May. Many economists had expected a much more robust sales report.

|Not About to Happen'

"A Fed tightening is not about to happen anytime soon," said John Lonski, senior economist at Moody's Investors Service.

And that's good news for banks. "Market worries about bank margins getting squeezed by higher short-term rates are probably premature," said Sung Won Sohn, chief economist at Norwest Corp. in Minneapolis.

The economic news bolstered the stock and bond markets on Friday. The yield on the 30-year Treasury bond fell to 6.80% from 6.87%. The Dow Jones industrial average rose 13.29 points to 3505.01.

Tightening Made Difficult

The latest update on another key inflation number, the consumer price index, won't be reported until Tuesday. But economists said Friday's report now makes a rate hike unlikely, regardless of what is reported Tuesday.

"It would now take a much bigger increase in CPI to prompt a tightening," said William Sullivan, money market economist at Dean Witter, Discover & Co.

Consumer prices would have to jump more than 0.4% to re-kindle inflation fears, economists said.

Awaiting the Next Round

"This will buy the Fed time to see how the next round of inflation numbers look," said Charles Lieberman, money market economist at Chemical Securities Inc.

For banks, the absence of moves by the Fed to coax short-term rates higher means the current operating environment will continue a bit longer. And that's good news because banks have thrived in that environment.

The Federal Deposit Insurance Corp. reported last week that the nation's banks earned a record $10.9 billion in the first quarter, with problem assets dropping to their lowest level in three years.

A Boost for Profits

Banks owe much of the robust earnings to low short-term interest rates, which keep down funding costs. Relatively high longterm interest rates, in turn, give banks decent returns on loans and securities.

In addition, noted Eugene Sherman, chief economist at M.A. Schapiro & Co., the current low-inflation environment means banks can continue to keep the lid on noninterest expenses.

Another positive: Loan demand is so slack that new problems are not emerging.

This allows banks to keep loan losses under control. The high level of loan-loss reserves permits banks the luxury of not having to pay for old problems with current earnings, Mr. Sherman said.

Fears at Fever Pitch

Fears about bank margins have reached fever pitch recently.

High inflation reports for April combined with rising commodity prices convinced the Fed to adopt a pro-tightening bias at the most recent meeting of the Federal Open Market Committee.

After reports of strong housing and employment growth in May, a tightening seemed inevitable, and interest rates shot up in the bond market. For the first time in years, economists were suggesting that the prime and other lending rates would head higher by yearend.

The Correct Reading?

But the latest figures raised questions about whether the Fed has correctly read the economy.

"Friday's data have got to raise red flags over where the economy is going," Mr. Sullivan of Dean Witter said. "The slide in consumer confidence could worsen by an application of monetary policy."

Philip Braverman, chief economist at DKB Securities, a unit of Dai-Ichi Kangyo Bank, predicted that the spread between the federal funds rate and fixed-rate loans will widen.

|In Desperate Shape'

Mr. Braverman, a well-known bear on the market, thinks that the economy "is in desperate shape" and that interest rates will fall sharply by yearend. He predicted that the yield on the 30-year bond will fall to between 6.25% and 6.50% by yearend and that the bond-equivalent yield on the three-month Treasury bill - at 3.12% on Friday - would fall to 2.75%.

Other economists still believe the economy will pick up speed later in the year and that rates will rise.

For example, Mr. Lonski of Moody's said he expects the 30-year bond to yield 7.50% at yearend. And he expects the target for the federal funds rate to be 50 basis points higher at yearend.

The Fed has kept its target for the funds rate at 3% since September 1992. It last tightened credit in May 1989.

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