Aug. 17 (Bloomberg) -- The Federal Reserve lowered the interest rate it charges banks and acknowledged for the first time today that an extraordinary policy shift is needed to contain the subprime-mortgage collapse that began roiling the world's financial markets two months ago.

The Fed, in a surprise announcement in Washington, cut the so-called discount rate by 0.5 percentage point, to 5.75 percent. Policy makers dropped language indicating their bias toward fighting inflation, and instead highlighted a rising threat to economic growth. That suggests officials will reduce their benchmark rate when they meet Sept. 18, economists said.

``This telegraphs their intention to cut rates at the next meeting,'' said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``This discount rate cut calms the market and helps financing.''

This is the first unanticipated reduction in borrowing costs between scheduled meetings since 2001, and Ben S. Bernanke's first as Fed chairman. Officials kept the benchmark federal funds rate target for overnight loans between banks at 5.25 percent. Policy makers next meet to set the rate on Sept. 18. Futures indicate traders anticipate at least a quarter-point cut.

Stocks Climb

The Fed's decision ignited a rally in stocks from Europe to the U.S. The Standard & Poor's 500 index climbed the most in four years, rising 2.5 percent, to 1,445.94. The Dow Stoxx 600 Index of European shares added 2.1 percent to close at 359.65. Treasuries were little changed, with the benchmark 10-year note closing at a yield of 4.68 percent.

FOMC members held a 6 p.m. conference call yesterday, spokeswoman Michelle Smith said in Washington. The Board of Governors met after to accept requests by the New York and San Francisco Fed banks to cut the discount rate. St. Louis Fed President William Poole skipped the FOMC call to keep a dinner appointment and avoid tipping the Fed's hand, spokesman Joseph Elstner said.

Meanwhile, Treasury Secretary Henry Paulson spoke with President George W. Bush to update him on market developments, White House spokesman Gordon Johndroe told reporters in Crawford, Texas. Bush has ``full confidence'' in the Fed, he added.

The Fed said while recent reports indicate economic growth continues at a ``moderate pace,'' risks to the expansion have risen ``appreciably.'' The statement is a marked change from just 10 days ago, when officials kept rates unchanged a ninth straight time and reiterated inflation was their ``predominant'' concern.

`Prepared to Act'

``Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth,'' the Federal Open Market Committee said today. ``The committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects.''

The last time the Fed enacted emergency rate cuts was in 2001, first in reaction to the bursting Internet bubble and then in the aftermath of the Sept. 11 terrorist attacks. In total, the Fed cut its benchmark rate 11 times that year, reducing it to 1.75 percent from 6.5 percent.

Once a key barometer of Fed policy, the discount rate has faded in relevance since 1994, when the FOMC began discussing its federal funds rate stance. This is the first time since then that policy makers changed the discount rate alone. Four years ago, the Fed altered the structure so that the discount rate is now above, rather than below, the benchmark rate.

The discount window can still serve a major role. The day after the Sept. 11 terrorist attacks, the Fed lent banks $46 billion, more than 200 times the daily average over the prior month. It was like opening the ``floodgates of a great dam,'' then-Vice Chairman Roger Ferguson said.

Geithner's Role

New York Fed President Timothy Geithner encouraged the Clearing House, a group of major banks including Citigroup Inc., JPMorgan Chase & Co. and Goldman Sachs Group Inc., to hold a conference call today. On the call, Geithner and Fed Vice Chairman Donald Kohn encouraged banks to use the discount window and said it was a ``sign of strength,'' the group said in a statement.

Officials today also extended so-called discount window borrowing, allowing 30-day financing instead of a standard overnight loan. The Fed's board sets the discount rate while the FOMC, which includes the governors and heads of five of the 12 district banks, determines the federal funds target rate.

Among the New York Fed's directors are JPMorgan Chief Executive Officer Jamie Dimon, Lehman Brothers Inc. CEO Richard Fuld and General Electric Co. chief Jeffrey Immelt. The remaining district banks later requested the same discount-rate cut.

Cash Infusions

The Fed acted today after its injections of cash into the federal-funds market in the past week failed to ease companies' access to capital. While there were enough funds to drive the effective federal funds rate below the 5.25 percent, credit in other markets was scarce.

The amount of commercial paper outstanding, a key financing tool, fell the most in the week to Aug. 15 since the 2001 terror attacks. Countrywide Financial Corp., the biggest U.S. mortgage lender, tapped an entire $11.5 billion bank line yesterday to get funds.

``This is an attempt to wake the world up,'' said John Roberts, managing director and head of government bond trading at Barclays Capital Inc. in New York. ``The system is flush in overnight money. Where the system is stacked up is in term funding.''

Housing Recession

The Fed's action reflects alarm that more restrictive lending and market volatility in will deepen the housing recession and weaken employment. As recently as the Aug. 7 meeting, the FOMC said inflation was still the biggest danger to the economy. Today's statement, approved unanimously by 10 Fed governors and presidents, didn't mention inflation.

Bernanke and his colleagues changed tack as losses mounted on subprime securities and concern spread that major lenders would be harmed.

Merrill analysts raised the risk in an Aug. 15 report that Countrywide could go bankrupt. JPMorgan, the biggest lender in the leveraged buyout market, may forfeit about $1.4 billion of second-half profit because of loans it can't sell, according to Keith Horowitz, an analyst at Citigroup.

At the same time, there are signs that inflation, the Fed's preoccupation up to now, is receding. The Fed's preferred gauge, which excludes food and energy costs, rose 1.9 percent in the 12 months to June, the lowest rate in three years.

Price Expectations

Investors' expectations for inflation have also stayed contained. A measure derived from differences in yields on five- year Treasury inflation-protected securities and regular notes fell to 2.43 percent today, little changed from 2.37 percent at the start of the year.

The gold market sounded a warning on inflation today, though, some traders said. A traditional hedge against higher prices, gold climbed $4.59 to $656.60 an ounce. The metal may extend the rally on signals the Fed wants to halt the credit crisis, rather than curb inflation, said Walter Otstott, a broker at Dallas Commodity Co. in Dallas.

There are some signs consumers will suffer the impact of falling real-estate prices and dwindling ability to tap home equity. Consumer confidence fell to the lowest level in a year this month, a private report showed today. The Reuters/ University of Michigan preliminary index fell to 83.3 from 90.4.

``You're getting a contagion effect on Main Street and any rational person would be downgrading their forecast'' for growth, said Paul McCulley, a money manager in Newport Beach, California, at Pacific Investment Management Co., which runs the world's biggest fixed-income fund. ``All the pieces are coming into place for the beginning of an easing'' in the Fed's benchmark rate.

Biggest Challenge

The subprime rout is the biggest challenge for Bernanke, 53, since he took office in February 2006. Under predecessor Alan Greenspan, the Fed in 1998 cut interest rates three times as currency crises in emerging markets roiled Wall Street.

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 90 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.

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.

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.

To contact the reporters on this story: Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: August 17, 2007 18:41 EDT