Fed Slashes Rate by 75 Basis Points

Updated from 3:06 p.m. EDT

Stocks roared ahead on sudden hopes that Wall Street's bear market has hit bottom after the Federal Reserve cut its key interest rate target by 75 basis points, stopping short of the stock market's great expectations.

The central bank lowered the federal funds rate target to 2.25% from 3%. It also lowered the discount rate, the rate at which it lends to banks directly, by 75 basis points to 2.5%. It was the second cut to the discount rate in three days.

The market had been pricing in a full percentage-point cut in an environment jittery after the swift and shocking demise over the weekend of Bear StearnsBSC, a major Wall Street investment bank.

"The Fed's decision today was anti-climactic after what happened over the weekend, and now there seems to be a bid out there for some of this mortgage-backed paper," says James Paulsen, chief investment officer with Wells Capital Management. "There's a sense developing that the Fed has finally gotten out in front of this crisis, and maybe we're at a bottom."

For its part, the central bank acknowledged that economic growth has weakened further recently amid a slowdown in consumer spending and the U.S. labor market, new language in its accompanying policy statement about inflation signaled that the Fed's continued willingness to keep pouring fresh liquidity into the financial system is approaching its limits.

"Inflation has been elevated, and some indicators of inflation expectations have risen," the statement said. "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. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully."

The announcement also contained evidence of growing divisions on the Federal Open Markets Committee, as two members -- Richard Fisher and Charles Plosser -- dissented from the majority, preferring less aggressive action at the meeting.

The market pulled back on the news briefly, but then mounted another strong rally. The Dow Jones Industrial Average closed up 3.5%, while the S&P 500 and the Nasdaq Composite both added 4.2%.

"In the circumstances, it is hard not to welcome a 75 basis point easing but we think the signaling power of a 1% move would have been very powerful," said Ian Shepherdson, chief U.S. economist with High Frequency Economics. "Instead, we now know that the Fed is split, with at least two FOMC members still fretting about inflation."

The fed funds rate is now at its lowest level since 2004. Before Tuesday's announcement, the Fed had already slashed 225 basis points from its fed funds rate since the credit crisis began last fall -- with 125 basis points of the move coming in January alone.

The Fed's aggression is a sign of the magnitude of damage to the financial system and the U.S. economy that central bankers see as a potential in the continuing credit crisis. Meanwhile, critics have pointed to inflationary signs that are popping up in price statistics, commodities markets and currency markets as evidence that the Fed is over-stepping boundaries.