The move, announced at the end of a much-vaunted two-day meeting of Fed policy-makers, was aimed at averting a slowdown in the economy, or even a recession, after a long period of recovery.
Prime rates moved down in response, with BankAmerica and three of the other major banks immediately announcing reductions and others expected to follow today and tomorrow.
The Fed's announcement ended days of suspense on Wall Street, where the Dow Jones Industrial Average soared 48.77 points to close at 4664.20.
Analysts had been evenly divided over whether a rate cut would be agreed. While many of the recent economic figures have pointed to a slowdown, notably a sharp drop in manufacturing, there have also been some contrasting statistics suggesting that any contraction would be only shallow and brief.
The US move sets the scene for lower interest rates elsewhere and takes the pressure off base rates in Britain. The Bank of France cut rates a quarter point yesterday and minutes after the Fed decision its Canadian counterpart announced its fourth cut in a little more than a month.
Some dealers hold out lingering hopes of a reduction in German rates at next week's Bundesbank council meeting
Alan Greenspan, chairman of the Federal Reserve, commented: "As a result of the monetary tightening initiated in early 1994, inflationary pressures have receded enough to accommodate a modest adjustment in monetary conditions."
Over a 12-month period ending last February, the Fed doubled US rates with seven consecutive increases. However, Mr Greenspan warned in a speech two weeks ago that there was a chance that the second quarter of this year could show a brief return to recession.
Earlier yesterday, the government's own forecasting gauge for economic prospects for the next six months - its index of leading economic indicators - showed a decline of 0.2 per cent in May, its fourth in as many months. Three monthly drops in the index are the classic signal of a recession.
Economists expect further interest rate cuts. Gerard Lyons, at DKB International, said: "The Fed will gradually ease rates further."
Earlier yesterday the Bank of France announced the expected quarter point cut in its key short-term interest rate. The bank had said earlier this week that conditions for an orderly easing of rates were in place. Further reductions are likely.
A few analysts believe German rates could fall when the Bundesbank council meets next week for the last time before its one-month summer recess. There has been evidence, including yesterday's publication of an unexpected jump in unemployment last month, that the pace of growth has slowed. .
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