The US Federal Reserve leapt to the rescue of the fragile American economy yesterday and cut its key interest rate by a half-point, sparking euphoria in US and global markets.

It was the first cut in US official rates in more than four years and came amid continuing market turmoil driven by fears for the health of the global financial system.

Stocks soared in response to the central bank decision. On Wall Street, the Dow Jones industrial average staged its sharpest one-day points gain for almost five years and its steepest percentage rise since spring 2003. The Dow closed up 335.97, or 2.5 per cent, at 13,739.47. The broad-based S&P index of US blue chips rose 2.8 per cent.

Benchmark ten-year Treasury bond prices fell, however, as markets suffered renewed nervousness over inflation, while the dollar sagged, pushing the euro to a record high of $1.3968, and the pound back above $2.

Although the Fed had been expected to cut its target for the Federal Funds rate, the key US policy rate, there was widespread uncertainty as to whether the cut would be a quarter- point or a half-point. In the end, Ben Bernanke, the Fed Chairman, and his colleagues seemed to have opted to swallow concern that an aggressive move might be seen as a bailout of financial institutions that had engaged in irresponsible lending in the past few years. Instead, they signalled that they are alert to the dangers that the financial stresses of the past two months could cause a serious economic slowdown and they cut the Fed Funds rate from 5.25 per cent to 4.75 per cent.

The Fed said: “The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”

The Fed also cut its discount rate, for lending to banks on an emergency basis, by a half-point to 5.25 per cent.

Problems in the US sub-prime mortgage market grew over the summer, culminating in a full-blown crisis last month. Uncertainty about the size of sub-prime losses has caused investor panic and some financial institutions have suffered extreme difficulty gaining access to financing.

In the past week the Bank of England has been forced to provide financial support to Northern Rock, and for the past month the European Central Bank has been providing special injections of liquidity to financial institutions. The Fed also increased its own supply of funding to banks last month.

Although US markets seem to have steadied recently, risks of financial strains remains high, analysts say. There have been signs of broader US economic weakness. Last month, US employment suffered its first fall for four years, fuelling fear of recession.

Explore Economics

• Pre-Budget Report 2009

• Budget 2009

• World Economic Forum

• The Times MPC

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive