The Federal Reserve made a big bet on interest rates last week - at least as far as banks are concerned.

The central bank is wagering that its cuts in short-term rates, and the ensuing reductions in the prime rate, will jump-start the economy by igniting borrowing.

Falling rates are almost always beneficial for banks. But this time the drop could backfire by squeezing profit margins without spurring loan demand.

Key to Recent Turnaround

The spread between banks' cost of funds and what they earn on loans, usually measured by the net interest margin, has been a key element in the banking industry's turnaround this year.

The problem is that the rates banks pay on deposits are already rock-bottom, and it is unlikely banks will be able to nudge them down much further. If banks are unable to match the half-percentage point out in the prime rate by reducing deposit rates, margins will be squeezed.

And some analysts worry that banks will feel the pressure on margins before they see a pickup in loan demand.

"There will be more discomfort from the cut in margins in the short term than comfort from an increase in loan volume," said Lawrence Cohn, analyst at PaineWebber Inc.

Last Thursday, the Fed cut the discount rate by 50 basis points, to 3% and its target for the federal funds rate by the same amount to 3.25%, the lowest levels for both since the early 1960s. Banks responded by cutting their prime rates by 50 basis points to 6%, the lowest level since 1967.

Employment Still Lags

The easing followed an employment report that was much weaker than expected. The Labor Department on Thursday reported a rise in the unemployment rate last month to 7.8% from 7.5%.

The overall stock market slumped on the employment report. But bank stocks rallied on the easing.

Richard Stillinger, an analyst at Keefe, Bruyette & Woods. Inc., said net interest margins are so high that banks could absorb a cut without suffering seriously reduced earnings. He added that banks were still benefiting from improved asset quality.

Dependence on Deposits

Traditionally, cuts in short-term rates are universally cheered by bankers and analysts. However, banks in recent years have increased their dependence on consumer deposits, reducing their reliance on wholesale sources of funding, such as the federal funds market and the Fed's discount window.

Thus, cuts in the federal funds rate and discount rate will not have a big impact on many banks, said analysts.

Banks have been ratcheting down deposit rates this year, while the prime rate had not moved. As of July 1, the average rate on bank money market deposit accounts was 3.34%, a 64-basis-point drop since the beginning of the year.

In the same period, the average rate for six-month certificates of deposit had fallen 37 basis points to 3.68%, according to the Bank Rate Monitor, a company in West Palm Beach, Fla., that tracks bank rates.

In some cases, jumbo certificates of deposit pay lower interest rates than comparable U.S. Treasury bills.

"I don't think banks can push rates very much further, and it will take a while to do so," said Mr. Stillinger.

Mortgage activity is one area likely to revive as a result of the easing.

The bond market rallied on Thursday, with the yield on the 30-year Treasury bond dropping 12 basis points, to 7.63%, and the 10-year Treasury note dropping 15 basis points, to 6.92%.

As a result, mortgage rates are likely to drop to their lowest levels in 20 years.

Mortgage lenders are likely to lower the rate on 30-year fixed-rate mortgage to about 8.2% this week from about 8.4% previously, said David Berson, chief economist for the Federal national Mortgage Association.

That would bring mortgage rates to slightly below the level that fueled record refinancings early this year.

He said the rate cuts also would help home sales - but not as noticeably as refinancings. The country's weak employment conditions suggest that many consumers are worrying about job security and income and, as a result, will lack the confidence to buy homes, Mr. Berson said.

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