The Dow Jones, which opened at 1430GMT, fell around 300 points or 2.5% in early dealing.
"It is obviously a surprise but it seems the markets could not wait for the promised rate cut at the end of the month and neither could the Fed given the behavior of the markets over the last few days," said Kevin Logan, an economist at Dresdner Kleinwort Wasserstein in New York.
Al Jazeera's John Terrett in New York said the move could be interpreted as a sign that the US central bank had acted quickly to diffuse fears of recession.
However, he also said it could stoke worries about the US economic system.
He said: "People could be saying 'what does the federal reserve know that we don't know?'
"We are going to see all this played out in the drama of the New York stock exchange."
European stock markets, which had dropped sharply on Monday and Tuesday, rose following the interest rate cut.
The UK's FTSE 100 closed up 161.9 points at 5,740.1, having fallen as much as 4.3 per cent earlier in the day.
Asian markets, which all fell substantially on Tuesday, closed before the announcement had been made.
It was the largest single shift in interest rates since November 1994, when the bank raised rates by three-quarters of a point.
Mumbai Sensex -4.97%
|Tokyo Nikkei 225
|Hong Kong Hang Seng
It was also the first rate cut in between regularly scheduled policy meetings since September 17, 2001, the first day US financial markets reopened after the September 11 attacks.
George Bush, the US president, last week announced a $145bn emergency plan in attempt to stimulate the economy.
On Monday, European markets appeared to have decided that the package was insufficent to prevent a looming recession in America.
Markets there fell, while US markets remained closed for Martin Luther King Day.
The markets have seen great volatility since last year when hundreds of thousands of low income US homeowners defaulted on loans which had been given out with little or no down payment.
The 'sub-prime' crisis led to US lenders such as Citibank and Merrill Lynch announcing in recent weeks that they had lost tens of billions of dollars.
That situation in the US has been compounded by higher unemployment rates, rising food prices and oil at around $100 a barrel.