The federal funds rate was lowered 25 basis points to 3.75 percent, a seven-year low. In its statement, the Fed said it remains concerned about the sagging U.S. economy, adding that it sees conditions that indicate further deterioration.
On the stock markets, the Nasdaq composite index and Dow Jones industrial average dipped lower soon after the Fed announcement but then recovered, perhaps indicating that some investors expected the Fed to cut rates by as many as 50 points.
"Obviously, the market was thinking that 50 points was a long shot, but they were hoping for it," said Michael Palazzi, head of Nasdaq trading at CIBC World Markets, an investment bank. Palazzi said that trading in Fed futures revealed that most people expected a 25-point cut.
The Fed also lowered the discount rate, the interest rate it charges banks to borrow, by 25 points to 3.25 percent. The funds rate is the amount of interest banks can charge each other to borrow.
In its announcement, the Fed included a short list of troubling economic signs, such as declining spending by businesses on capital equipment and less shopping activity from U.S. consumers.
"The patterns evident in recent months--declining profitability and business capital spending, weak expansion of consumption, and slowing growth abroad--continue to weigh on the economy," the Fed said in its statement.
The Fed also noted some positive trends in the economy, such as the adequate supply of workers and materials, which has prevented companies from raising prices, muffling inflation. "The associated easing of pressures on labor and product markets are expected to keep inflation contained," the Fed said.
"People are still very worried that the economy is weak and are very worried that there are not enough things to turn it around," Palazzi said, noting concerns over the world economy. But Palazzi believes the stock markets will rally this week because of the Fed decision.
In 1999 and 2000, the Fed raised the funds rate six times for a total increase of 1.75 percentage points to a high of 6.5 percent in May. It also hiked the discount rate five times, to 6 percent, an increase of 1.5 percent.
However, recent economic data have indicated that the U.S. economy might be slowing too much, so the Fed started its assault Jan. 3 and has lowered rates by a half-point each time since.
The Federal Reserve's primary focus is to contain inflation, and its main instrument is interest rates. When it senses the economy is growing at a rate that could ignite inflation, it often raises rates, which raises the cost of borrowing money and pinches corporate financial activity.
But when the economy seems headed for trouble, the Fed decreases rates. Lowering interest rates makes it less costly for businesses to finance expansion plans, sparking economic growth. Lower rates can result in more stable stock prices, too, because interest-paying investments become less attractive.
The Federal Reserve's policy-making committee meets again Aug. 21.