If the Fed is cutting interest rates, shouldn’t Libor also fall along
with it? Assuming that the difference from the prime rate and the libor rate is the interest banks make from lending dollars, shouldn’t the spread be narrowing as the Fed cuts rates. I just don’t see any reason why Libor is still continuing to rise.
You are on the right path.
As you pointed out, there is a spread. In the Financial world, this is called the "Ted Spread". The Ted Spread has been widening because it is a function of supply and demand. US Libor is influence by many different bond instruments, but mortgage backed securities are by far the biggest part of the demand side. Normally, with all else being equal, the Ted Spread stays stable when the Fed Rate falls, which leads to lower interest rates. But this is not the case.
As you’ve read in every newspaper, the mortgage industry in the US is the dog house with volumes way down. The spread is widening while the base rate (Fed Rate) is falling, with net-net higher interest rates.
This is not necessarily a bad thing. It’s more of a normalization from "giving a mortgage to everyone who has a pulse" to "giving mortgage to people who are suppose to have them".
The Ted Spread should normalize by 1Q08 as soon as Sub-Prime bottoms out.
Moneysupermarket.com expert Clare Francis is with expert Kevin Mountford to discuss the implications of the MPC decision to cut 
Brief illustration of a fixed-for-fixed currency swap (e.g., dollars for euros). Please note: in a plain vanilla 
An FRA is a contract that lets the buyer (who is long the rate) lock-in an interest (borrowing) rate. In this example, the FRA buyer locks in LIBOR at 3%
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