Aug. 17 (Bloomberg) -- The Federal Reserve unexpectedly cut the discount rate and said it's prepared to take further action to ``mitigate'' damage to the economy from the rout in global credit markets.

The central bank reduced the rate at which the Fed makes direct loans to banks by 0.5 percentage point to 5.75 percent. Policy makers kept their benchmark federal funds rate target unchanged at 5.25 percent. Today's action is the first reduction in borrowing costs between scheduled meetings of the Federal Open Market Committee since 2001 and Ben S. Bernanke's first as Fed chairman.

``Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth,'' the FOMC said in a statement released in Washington. ``The downside risks have increased appreciably.''

The committee is ``prepared to act as needed to mitigate the adverse effects on the economy arising from disruptions in financial markets,'' the statement said. The Fed's Board of Governors released a separate statement announcing the discount- rate cut.

U.S. Treasury notes erased gains and stock-index futures rallied. The yield on the benchmark 10-year note was up 7 basis points at 4.72 percent as of 9:13 a.m. in New York. Futures on the Standard & Poor's 500 index rose 2.1 percent to 1,455.

Adding Funds

Until today, the Fed had been injecting extra funds into the banking system to meet rising demand for cash. That didn't help companies much in getting access to capital. The amount of commercial paper outstanding, a key financing tool, has fallen the most since the 2001 terror attacks.

Today's action ``will basically do more to unclog the credit channels than a fed funds rate cut would have,'' said Drew Matus, senior economist at Lehman Brothers Holdings Inc. in New York, who used to work at the Fed. ``It I think it was exactly the right thing to do.''

The reduction and statements reflect alarm at the central bank that more restrictive lending conditions and volatility in financial markets will deepen the housing recession, weaken employment and erode economic growth. As recently as its Aug. 7 meeting, the FOMC kept rates unchanged and said inflation is still the biggest danger to the economy.

The Fed noted then that ``financial markets have been volatile,'' though the economy was still expected to continue to expand at a ``moderate'' pace. Today's FOMC statement didn't mention inflation.

Global Action

In the past week, the Fed and central banks in Europe, Japan, Canada and Australia have been compelled to add money to the banking system. The collapse in demand for securities backed by subprime mortgages has forced at least 70 lenders out of business.

The European Central Bank began adding liquidity on Aug. 9 after BNP Paribas SA, France's biggest bank, was forced to halt withdrawals from three of its investment funds. The Fed followed, along with counterparts from Sydney to Oslo.

Today's move also shows how Bernanke, like his predecessor, is prepared to temporarily abandon Fed growth forecasts and inflation objectives to offset the risk of a credit crunch. Former Chairman Alan Greenspan was known for his tendency to give financial market conditions a primary role in policy, and he came to the rescue on several occasions when turmoil struck.

Requests From Banks

The Fed said in cutting the discount rate, it was approving requests from the boards of directors of the New York and San Francisco district banks. Among the New York Fed's directors are JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon, Lehman CEO Richard Fuld and General Electric Co. CEO Jeffrey Immelt.

Mortgage defaults by Americans with poor credit histories prompted the collapse in June of two hedge funds managed by Bear Stearns Cos. and triggered a worldwide rout in the debt markets. Companies such as London-based Cadbury Schweppes Plc have delayed asset sales, and banks including JPMorgan Chase & Co. and Deutsche Bank AG have been left on the hook for as much as $300 billion of debt they've agreed to provide.

``The credit markets are beginning to seize up a little bit,'' Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University in Atlanta, said before the decision. ``The economy is weak, job growth is lackluster.''

Job Growth

Employers in the U.S. added a fewer-than-forecast 92,000 workers to payrolls last month and the jobless rate rose to 4.6 percent from 4.5 percent. Indexes tracking U.S. manufacturing and service industries also slowed more than expected in July, according to the Institute for Supply Management. Auto sales last month were at their lowest level in nine years.

``This is not a sign of balanced and healthy growth economy,'' Dhawan said.

Gross domestic product expanded at an annual pace of 3.4 percent in the second quarter, up from 0.7 percent in the previous three months. Consumer spending, which kept the economy afloat for much of the past year, slowed. Growth was underpinned, instead, by exports and corporate investment.

Growth Outlook

Economists and policy makers anticipate a slower expansion in the second half. For the year, Fed governors and presidents expect growth, on average, of about 2.25 percent to 2.5 percent, Bernanke told Congress last month. The projections are about a quarter-point below the last round in February, mainly on weakness in homebuilding.

The Standard & Poor's 500 Index has fallen 8.9 percent in the past month.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net; Brendan Murray in Washington at brmurray@bloobmerg.net.

Last Updated: August 17, 2007 09:21 EDT