The central bank also pumped six billion dollars into the stressed financial system, adding to the 88 billion dollars injected from August 9.
The rate alteration made by the Fed is extremely rare outside of a scheduled interest rate meeting.
It last did so on September 17, 2001, after the September 11 attacks that targeted New York and Washington.
John Silva, a chief economist at Wachovia Corporation, said: "[The] Fed has effectively eased [interest rates] through the back door ... It is not clear if there is a single bank problem or if this is a response to general liquidity shortage."
The Dow Jones Industrial Average stock barometer closed up over 230 points, or 1.82 per cent, at 13,079.08 after rocketing over 300 points immediately after the Fed cut the discount rate.
Wall Street has been pummeled this week as investors fretted over evaporating credit tied to the ailing mortgage market.
White House spokesman Tony Fratto said Treasury Secretary Henry Paulson had briefed George Bush, the US president, on the market situation late on Thursday.
The White House had "full confidence" in the Fed, Fratto said.
Mounting home foreclosures, which have forced dozens of mortgage lenders out of business and triggered multibillion dollar losses for large hedge funds that bought mortgage-backed securities, have forced banks to tighten their lending standards.
The Fed's move does not affect its key short-term federal funds interest rate which stands at 5.25 per cent, although some investors have called for a rate cut.
The central bank said it had trimmed its discount rate to restore "orderly conditions in financial markets" which have been rocked by credit fears.
"Although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably," it said.
Analysts worry that a sustained downturn on Wall Street is threatening US economic growth, which accelerated to a 3.4 per cent annualised clip in the second quarter after a weak 0.6 per cent pace in the first quarter.
Ready to act
The Fed said it was ready to act as necessary "to mitigate the adverse effects on the economy arising from the disruptions in financial markets".
The rate action came as Fed chairman Ben Bernanke, a former academic, faced his first crisis since taking office last year.
Stephen Gallagher, an economist at Societe Generale, said: "This step is a considerable move to inject liquidity into the system well beyond the previous liquidity injections."
It remains to be seen whether the Fed will have to act further to resolve the financial jitters.
Andrew Tilton, an economist at Goldman Sachs, said late on Thursday: "In some cases, credit is not available at any price."
Credit in the subprime mortgage sector, which has sparked the lion's share of home foreclosures, has dried up dramatically.
Hundreds of thousands of subprime loans, loans granted to Americans with sketchy finances, were made during the housing boom which fizzled out in early 2006.
Some economists say the market problems have increased the odds that the Fed will cut its fed funds rate at a meeting scheduled for September 18.