The US central bank cut its Federal Funds rate by one quarter of a percentage point, from 5.5 per cent to 5.25 per cent.
One bank, the Southwest Bank of St Louis, had already pre-emptively cut its prime lending rate by a half-point, and market analysts had been divided over how far the Fed would cut. The Fed left its discount rate unchanged at 5 per cent.
Wall Street had been up before the announcement, but the news of the size of the cut left it unhappy and the market fell back rapidly. The Dow Jones industrial average closed down 28.32 points, or 0.35 per cent, at 8,080.52. Although it has recovered from the correction in August, the market is still nervous.
The problems of Long-Term Capital Management forced the Fed to step in and organise a rescue package last week, and the impact is still being felt on Wall Street.
It will be months before all of LTCM's positions are unwound, and the crisis exacerbated an existing trend: lenders were shifting to safer investments, leaving some hedge funds highly exposed.
The degree of concern was evident in the decision late on Monday night by Goldman Sachs to cancel, rather than merely postpone, its public offering.
There were further signs of trouble on Wall Street last night as Arthur Levitt, chairman of the Securities and Investment Board, warned that other hedge funds may be in difficulties.
The Federal Reserve had signalled the cut in Congressional testimony last week by Alan Greenspan, the Fed Chairman. He had pointed to economic weakness abroad and a looming liquidity crunch at home as reasons why monetary policy should lean toward loosening rather than tightening. Only two months ago, the Fed supremo was more concerned about rising wages and tight labour markets.
The Fed pointedly justified the cut by reference to domestic conditions rather than the global economy. "The action was taken to cushion the effects on prospective economic growth in the US of increasing weakness in foreign economies and of less accommodative financial conditions domestically," said a statement issued by the Fed.
"The recent changes in the global economy and adjustments in US financial markets mean that a slightly lower federal funds rate should now be consistent with keeping inflation low and sustaining economic growth going forward."
Yesterday's cut is the first shift of any kind in US interest rates since early 1997 when the Fed increased rates by a quarter point, and the first reduction in rates in three years.
The US economy has been on a steady track of low inflation and healthy growth, with little to rock its equilibrium until this year. But since 1997, the moderating effect of low inflation has shifted real interest rates up.
As credit conditions have tightened, stock markets declined and investors have fled toward quality investments, there have been serious problems of liquidity on financial markets.
Outlook, page 17