Fed cuts key interest rates by 3/4 point

By Mark Felsenthal

WASHINGTON (Reuters) - The Federal Reserve slashed a key U.S. interest rate by three-quarters of a percentage point on Tuesday, a substantial cut but smaller than many in financial markets had expected, as part of an effort to hold off a deep recession and financial meltdown.

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.

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.

U.S. stock markets trimmed earlier gains on the smaller-than-expected rate cut, but were still up sharply. Prices for short-term government debt extended losses and the dollar pared earlier gains against the Japanese yen.

"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.

CREDIT CONCERNS

The action comes two days after the central bank announced the latest in a series of emergency measures to stem a fast-spreading global financial crisis.

The Fed has now cut rates by 3 percentage points since mid-September, including 2 points since the start of the year. In recent days, the central bank has also unveiled steps not used since the Great Depression to ensure financial institutions have access to liquid funds.

The central bank is pulling out all the stops to provide liquidity to financial markets and put a floor under an economy many analysts believe is in recession.

A spike in mortgage delinquencies has escalated since the summer to a full-blown credit crunch that claimed venerable Wall Street institution Bear Stearns as its most prominent victim.

The Fed, fearing financial markets would freeze up and send the economy into an sharp downward spiral, has offered cash auctions and direct loans to financial institutions, opening those liquidity avenues beyond the banks that normally deal with the Fed to include other Wall Street firms.

In spite of a series of interest rate cuts and liquidity-providing measures, U.S. economic activity has decelerated sharply. Recent reports show a loss in jobs, reduced factory output and a drop in retail sales.

The U.S. central bank has set aside lingering concerns on inflation arising from a jump in oil prices, some of which is blamed on the continuing deterioration of the dollar's value.

The government has responded to the economy's abrupt slowing with a fiscal stimulus package aimed at putting cash in consumers' wallets. Lawmakers are also pushing for measures that would revive the struggling U.S. housing market by providing relief for homeowners who are delinquent in their mortgages and facing possible foreclosure.

U.S. Treasury Secretary Henry Paulson earlier on Tuesday conceded the economy was in decline. "There's no doubt that the American people know that the economy has turned down sharply," he told NBC's Today show.

(Additional reporting by David Lawder; Editing by Tim Ahmann)

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