The Fed's action, taken on an 8-2 vote of its policy committee, took the bellwether federal funds rate down to 2.25 percent, the lowest since February 2005. Financial markets had largely priced in a full point reduction.
"Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over
the next few quarters," the central bank said in a statement outlining its decision. (Click here to read the full statement.)
The Fed also said downside risks to economic growth remained even in the wake of the rate cut, suggesting an openness to a further lowering of borrowing costs if needed.
However, two Fed officials dissented, preferring less-aggressive action. Still, most policy-makers seemed to be counting on inflation to subside, partly because they expect unemployment to rise.
"The committee expects inflation to moderate in coming quarters, reflecting a projected leveling out of energy and other commodity prices and an easing of pressures on resource
utilization," the Fed said.
Stocks initially trimmed their gains on the smaller-than-expected rate cut, but then rebounded to their previous highs. Prices for short-term government debt extended losses and the dollar eased, then rebounded.
"The Fed has shown that they are focused on getting the economy back on its feet first and foremost, and they will worry about inflation later," said K. Daniel Libby, senior portfolio manager at Sands Brothers Select Access Fund in Greenwich, Connecticut.
The Fed's action takes the bellwether federal funds rate to 2.25 percent, the lowest since February 2005, and comes two days after the central bank announced the latest in a series of emergency measures to stem a fast-spreading global financial crisis.Many in financial markets had expected the Fed to chop the overnight rate by a full point.
The Fed has now cut rates by 3 percentage points since mid-September, including 2 points since the start of the year.