In a statement the Federal Open Market Committee said: "Recent information indicates that outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.
"Inflation has been elevated and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected levelling-out of energy and other commodity prices and an easing of pressures on resource utilisation. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.
"Today's policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as need to promote sustainable economic growth and price stability."
The decision was taken by eight votes to two, with Richard W. Fisher and Charles Plosser voting for a lesser cut.
In a related action, the Board of Governors unanimously approved a 75 basis point decrease in the discount rate to 2.5 per cent.
Earlier, stocks and credit markets rallied sharply as investors were buoyed by better-than-expected results from Lehman Brothers and Goldman Sachs and anticipated a big Fed rate cut.
First quarter earnings at the two Wall Street firms fell less than analysts had expected, easing concerns about the state of the investment banking sector.
At midday, the S&P 500 was up 2.5 per cent at 1,308.80, with the investment bank index higher by 12.6 per cent. Shares of Lehman Brothers were up 34 per cent at $42.50. European markets closed strongly ahead, with the FTSE 100 up 3.5 per cent.
Even Bear Stearns shares jumped, to nearly $8 as investors bet that shareholders might be able to get a better deal than the $2 a share price agreed by JP Morgan Chase for a rescue takeover.
There were signs of relief that the markets had stabilised on Monday following initial alarm over the terms of the Bear sale and the Fed's decision to offer emergency financing to all its primary dealers.
Treasury bond yields were much higher, as recent safe haven buying was reversed. The yield on the two-year note was 16 basis points higher at 1.50 per cent, while the yield on the 10-year note was 11bp higher at 3.42 per cent.
There was much better buying of mortgage and corporate bonds priced over Treasury yields. Interest rate and credit derivatives also rallied as stocks and financials were up sharply.
Ken Hackel, managing director of fixed income strategy at RBS Greenwich Capital said market conditions were improving and that the firmer tone stocks was a boost for fixed income markets. "There is relief that a Wall Street firm didn't go down."
However, he cautioned, "there is no doubt, liquidity will remain at a premium for some time."
The improved tone in spreads was also attributed to market rumour that a 30 per cent capital surcharge on Fannie Mae and Freddie Mac, the two government-sponsored enterprises, could be lifted. This would enable Fannie and Freddie to buy more mortgage assets with their existing capital.
However, such a move would expose Fannie and Freddie to greater credit risk, and for this reason has been opposed by their regulator in the past. Policymakers want Fannie and Freddie to raise more capital.
The dollar was mixed, weaker against the euro and sterling, but was up 1 per cent against the yen to Y98.20.
However, there was little good news on the underlying economy. While new home starts came in higher than expected, building permits plunged 7.8 per cent in February, suggesting further weakness to come.
Meanwhile core wholesale prices, excluding food and energy costs, as measured by the producer price index rose at their highest pace in more than a year, highlighting continued inflation risk.
US Treasury Secretary Hank Paulson admitted "the economy has turned down sharply" - though he avoided the word recession. He told NBC the "big focus on the part of all policymakers is to minimise the spillover to the real economy."