The bank hopes the move will boost consumer and business spending.
George Bush, the US president, said it was a challenging time for the US economy and that the government would take further action if necessary.
"If there needs to be further action we'll take it in a way that does not damage the long-term health of our economy." he said while making a speech about trade in Jacksonville, Florida.
Al Jazeera's John Terrett in New York said the success or failure of the policy prescriptions the Bush administration is using to "stimulate" the US economy will be determined many months from now.
|Bear Stearns was the latest bank to feel the |
pressure following the subprime crisis [AFP]
The Federal Reserve pointed to slowing consumer spending and high unemployment rates as part of the reason for continuing economic decline.
"Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters," the bank said in a statement.
While the cut was larger than the Federal Reserve's normal quarter-point moves, investors were initially disappointed that the US did not cut rates by a full percentage point.
The Dow Jones industrial average fell by 100 points within two minutes of the the announcement but it then resumed climbing and was up by almost 200 points half an hour after it.
The cut is the latest in a series of measures the US has taken in an attempt to head off a recession.
JPMorgan Chase, the US bank, said on Monday it had agreed to buy crisis-hit investment bank Bear Stearns with Federal Reserve backing.
The US has also made hundreds of billions available to banks in an attempt to get cash into the financial system.
US banks have reported losses of tens of billions of dollars after offering high interest mortgages that borrowers were later unable to repay.
The crisis has also affected international lenders, who bought into or offered subprime loans in the US and then contributed to bouts of chaos on international financial markets.