Fed offers modest rate cut

By Mark Felsenthal

WASHINGTON (Reuters) - The Federal Reserve cut interest rates by a modest quarter-percentage point on Tuesday, disappointing Wall Street hopes for bolder action but offering a bit more help to an economy facing credit strains and a deep housing slump.

The central bank's decision takes the bellwether federal funds rate, which governs overnight lending between banks, down to 4.25 percent. While the action was widely expected, some economists had thought the Fed might offer a bolder half-point reduction.

In a related move, the Fed trimmed the discount rate it charges for direct loans to banks by a matching quarter point. Here too, some market participants were dissatisfied. Many had thought the Fed would lower the discount rate by more than the federal funds rate to lubricate tight credit markets.

The blue chip Dow Jones industrial average .DJI closed down 294 points, or 2.1 percent, while prices for U.S. government bonds surged as investors sought safer assets.

"This was not what the market was looking for and did not move to clarify Fed intentions or assuage concerns of market participants of another leg down in the economy and resurgence of financial turmoil," said Joseph Brusuelas, chief U.S. economist of IDEAglobal in New York.

NAVIGATING A STORM

In a statement, the Fed noted financial strains had increased in recent weeks, but it also said some inflation risks remain. It refrained from offering its usual assessment of the balance of risks facing the economy, catching some economists off guard who had looked for the Fed to underscore its concerns about weakening economic growth.

"Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation," it said.

The Fed has now cut overnight rates, their key economic policy lever, by a full percentage point since mid-September in an effort to put a floor under an economy increasingly seen at risk of falling into recession.

"Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time," the Fed said.

The U.S. central bank acknowledged the economy was slowing, citing in particular the "intensification" of the housing sector's downturn. But it also said it was possible persistently high oil prices could push inflation up.

"The Fed is trying to navigate through a storm in which risks to growth have risen at the same time inflation expectations have drifted higher, a difficult balancing act," said Michael Darda, chief economist of MKM Partners in Greenwich, Connecticut.

RECESSION TALK

The Fed's decision follows renewed deterioration in credit markets after major financial institutions around the world reported billions of dollars worth of write-downs due to extensive exposure to delinquent mortgages.

Markets and policy-makers have been caught off guard by how hard and broadly rising defaults on U.S. subprime mortgages have hit. As roughly 1.8 million adjustable rate mortgages line up for reset at sharply higher interest rates in 2008, the prospect of more pain for homeowners and banks has increased since the Fed last met in October.