Fed cuts discount rate, signals growth concern

WASHINGTON (Reuters) - In a bold bid to turn back a rising financial storm, the U.S. Federal Reserve on Friday cut a key bank lending rate and signaled a willingness to take more dramatic action to cushion the economy from tightening credit.

With stock markets from Asia to New York reeling as shock waves from rising U.S. mortgage defaults spread around the globe, the U.S. central bank tried to calm financial markets by lowering the discount rate that governs Fed loans to banks by a hefty half-percentage point to 5.75 percent.

While it held the benchmark federal funds rate -- its main economic policy lever -- steady at 5.25 percent, the Fed said it stood ready to act to keep the U.S. economy on an even keel and many economists said rates would soon move lower.

"Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward," the Fed said in a rare statement issued between regularly scheduled meetings.

"Although recent data suggest that the economy has continued to expand at a moderate pace ... downside risks to growth have increased appreciably," it said.

Just 10 days ago, the Fed had said inflation -- not growth -- was its main concern, and the statement was seen as an abrupt about face for a central bank that had not wanted to be seen as bailing out investors who had taken unwarranted risks.

"The move this morning is a major shift in their economic viewpoint and is meant to send a message to the markets that their heads aren't in the sand and (that they) are proactive in addressing the credit crunch," said Chris Jarvis, an analyst with Caprock Risk Management in Hampton Falls, New Hampshire.

U.S. stock prices shot higher on the Fed's move, with the blue chip Dow Jones industrial average .DJI, closing up 233 points at 13,079. Prices for U.S. government bonds also rallied as traders saw the discount rate cut as a half-way point to easier monetary policy.

CREDIT CRISIS

A snowballing credit crisis has sparked major financial market falls in recent weeks as defaults on U.S. subprime mortgages choked off demand for risky high-yield loan derivatives. This plunged some hedge funds into dire financial straits and prompted banks to tighten loan standards, threatening economic growth.

Central banks began pumping hundreds of billions of dollars into the banking system last week, after French bank BNP Paribas froze $2.2 billion worth of funds hit by subprime woes, hoping to restart the flow of credit.

But those central bank moves had only limited success.

Canada's $108 billion commercial paper market nearly seized up on Tuesday when some institutions revealed problems raising cash to repay debt.

Then on Thursday the largest U.S. mortgage lender, Countrywide Financial Corp. CFC.N, set off alarm bells when it revealed that it had to draw down an entire $11.5 billion bank credit line as other short-term funding sources dried up. Customers queued up at offices, and jammed phone lines and the firm's Web site in an effort to pull out their cash.

The cut in the discount rate will lower the cost of capital and grease the financial system's gears by assuring banks they have access to adequate funding. The Fed also said it would make loans to banks for longer terms than usual.

"It's a message to the credit markets and the banks in particular: 'Carry on lending as you were before. Don't be frightened of running out of liquidity. We stand behind you full-square,'" said Edward Menashy, strategist with Charles Stanley in London.

The discount rate usually moves in concert with the federal funds rate, and the surprise reduction on Friday showed how serious the Fed views the recent financial market turmoil.

The last time any rates were cut between regular Fed meetings was on September 17, 2001, just days after terror attacks that had brought the U.S. financial system to a virtual halt.

Investors took Friday's move as a signal the Fed won't let market panic spin out of control and many said it was a major step toward a long hoped-for cut in the main benchmark overnight lending rate.

"This is a noticeable change in their view of the economy and they want to take action," said A.G. Edwards & Sons Inc. chief economist Gary Thayer in St. Louis, adding that he would look for a rate cut by the Fed's next meeting on September 18.