In a surprisingly strong move, the Federal Reserve unanimously voted to cut its overnight interest rate target by a half percentage point to 4.75% Tuesday, citing turmoil in financial markets as a threat to economic growth. U.S. stock markets rallied on the first cut in the federal funds rate in more than four years. Financial markets and analysts had been expecting a smaller quarter-point cut. The Fed also cut the discount rate by a half percentage point to 5.25%.

The federal funds rate is the rate banks charge each other for overnight loans to meet the Fed's reserve requirements. By buying and selling short-term Treasury bills, the Fed manipulates short-term rates in the market, allowing banks to increase or decrease the funds available for loans. Over the last month, the effective funds rate has been lower than the Fed funds rate. Some economists said it was an extra bit of liquidity from the Fed.

Ultimately, the fed funds rate influences even longer-term rates, such as mortgages, corporate bonds and Treasury notes. The separate discount rate is the rate it charges banks to borrow money from its discount window. Reducing the rate is seen as a way to add liquidity to financial markets. The rate, which has little impact on consumers, is set by the seven members of the Fed board of governors.

"Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," the Fed said in a statement.

The drop in the fed funds rate is expected to be matched almost immediately by banks dropping their prime lending rates. Bank of America lowered its prime rate within minutes of the announcement. Most banks peg their prime lending rate to the fed funds rate. The interest rates on many adjustable-rate mortgages and credit cards are pegged to the prime rate.

The committee said growth had been moderate but judged that "the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth." Ahead of the announcement, the National Association of Home Builders said confidence among builders fell to its lowest level in the 22-year history of its housing index, a sign that the housing market could continue to worsen in coming months. The FOMC signaled that further rate cuts could be coming, saying it would monitor the situation and that it stood ready to act if necessary.

Inflation readings had improved modestly, the FOMC said, but some inflation risks remain. The FOMC removed language from the August statement that the moderation in inflation pressures has yet to be "convincingly demonstrated."

Background:
The worst housing slump in 16 years is being painfully felt. Higher interest rates squeezed homeowners, especially "subprime" borrowers with blemished credit or low incomes. Foreclosures set records and late payments spiked. Lenders were forced out of business. Hedge funds and other investors in subprime-related mortgage securities got clobbered. The credit crisis spread beyond the subprime market to more creditworthy borrowers.

Bernanke and his colleagues were accused of being behind the curve when they held their key interest rate steady at 5.25% at their last meeting on Aug. 7. Just days later the Fed was forced to pump billions of dollars into the U.S. financial system to get institutions over the credit hump. Then on Aug. 17 the Fed took even more aggressive action and cut its lending rate for banks. The Fed on Tuesday lowered that lending rate again.

Text of FOMC statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent. Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Developments in financial markets since the Committee's last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Thomas M. Hoenig; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric Rosengren; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 5-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, St. Louis, Minneapolis, Kansas City, and San Francisco.