Sept. 19 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke adopted the approach of his predecessor Alan Greenspan, reducing interest rates to pre-empt an economic slump rather than waiting for one to occur.

The Fed yesterday lowered its benchmark interest rate by half a percentage point, surprising most economists and spurring the biggest rally in U.S. stocks since 2003. Policy makers said they based their decision on the ``potential'' for the sell-off in credit markets to hobble economic growth.

The cut may help alleviate the worst housing recession since 1991 and ease pressure on the Fed in Congress, where lawmakers had called for cheaper borrowing costs. The decrease may also quell criticism on Wall Street that Bernanke, 53, was slow to respond to stress in capital markets. Greenspan pared rates three times in 1998 as currency crises in emerging economies rippled across the globe.

``Bernanke and his colleagues have taken to heart the risk- management approach that Chairman Greenspan used,'' said Stephen Cecchetti, a former head of research at the Fed's New York branch who teaches economics at Brandeis University in Waltham, Massachusetts. ``You have to make sure the worst case doesn't happen,'' he said, and the Fed showed that it's ``prepared to go further.''

Sustainable Growth

The Federal Open Market Committee cut the federal funds rate, which banks charge each other for overnight loans, to 4.75 percent, against the expectations of 105 of the 134 forecasters in a Bloomberg News survey. The Fed said in its statement that it ``will act as needed to foster price stability and sustainable economic growth.''

Most analysts predicted a smaller cut after Bernanke warned in a speech last month that investors must accept their losses. ``It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions,'' he said.

Now Bernanke may be open to the charge of creating ``moral hazard,'' or encouraging investors to take on more risk because they think the Fed will make good their losses.

``I don't regard this as a particularly good move,'' said Lee Hoskins, former president of the Fed's Cleveland branch. The reduction simply delays the reckoning for investors who placed bets that went wrong when credit costs suddenly increased, he said.

Opportunity

Policy makers had thought ``this might be an opportunity to instill some financial discipline without too high a cost in terms of economic performance,'' said Neal Soss, chief economist at Credit Suisse in New York. ``Clearly the balance of that assessment has altered 180 degrees.''

The Dow Jones Industrial Average climbed 335.97 points to 13,739.39 after the announcement. The premium that investors demand to buy high-risk, high-yield corporate bonds compared with benchmark Treasuries fell to the smallest this month, Merrill Lynch & Co. data showed.

``FOMC now stands for Friend of Market Committee,'' said Chris Rupkey, chief financial economist at Bank of Tokyo- Mitsubishi UFJ Ltd. in New York. ``It is a bold step that is going to start to calm financial markets.''

The Fed also reduced the rate it charges banks for direct loans by half a point, to 5.25 percent.

Officials had opted to cut the discount rate, instead of their benchmark, on Aug. 17 as confidence deteriorated with the slump in assets tied to subprime mortgages.

Collateral

Policy makers had encouraged banks to use the resource by clarifying that the Fed would accept as collateral asset-backed commercial paper, one of the markets that has contracted with the mortgage debacle.

The approach spurred unease among some investors who advocated a broader cut in borrowing costs. During the past month, traders repeatedly speculated on an emergency move, and futures and Treasury notes reflected expectations for a series of reductions. On Aug. 20, the yield on three-month Treasury bills fell the most in two decades amid a flight to safety.

After the rate decision, Bernanke may get a better reception tomorrow when he appears before the House Financial Services Committee to testify on the credit-market rout.

Representative Barney Frank, the Massachusetts Democrat who chairs the panel, said in an e-mailed statement he was ``pleased'' with the cut. Frank called on Sept. 7 for a ``meaningful'' easing. Still, he said yesterday he was ``surprised'' the Fed continued to note concern about inflation.

`Risks Remain'

In its statement, the FOMC said ``some inflation risks remain,'' and it will ``continue to monitor inflation developments carefully.'' The reference shows officials are trying to keep open the option to reverse their move should the economy strengthen, economists said.

Longer-dated Treasuries dropped and gold prices rose after the decision. Yields on 30-year Treasury bonds increased 6 basis points to 4.75 percent late yesterday. A basis point is 0.01 percentage point. Gold futures climbed to a 27-year high of $735.50 an ounce.

The larger-than-expected rate cut ``is a repeat of a mistake that the Fed made over and over,'' said Allan Meltzer, a Fed historian and professor at Carnegie Mellon University in Pittsburgh. The Fed ``put all of its chips on the prospect of a possible recession, and very little on the possibility of inflation.''

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net;

Last Updated: September 19, 2007 00:13 EDT