Federal Reserve Chairman Ben Bernanke and his colleagues approved the cut after an emergency video conference called to discuss Monday's global stock sell-off. The drop in the world markets was fanned by fears that a possible recession in the U.S. economy could spread worldwide.
In a brief statement explaining its move, the Fed said that "appreciable downside risks to growth remain" and officials pledged to "act in a timely manner" to deal with the risks facing the economy.
Further rate cuts were likely, the Fed indicated.
But U.S. markets paused only momentarily Tuesday before the selling wave renewed in early morning trading.
Within minutes of the opening bell, the Nasdaq dropped to a level indicating it has crossed the threshold of what is considered a bear market -- down 20 percent from its October peak.
The Dow Jones Industrial Average plunged more than 460 points, but two-thirds of that loss was recovered by late morning as investors snapped up beaten-down retailers, home builders and financial services companies.
Analysts said the fact that the Fed did not wait until its meeting next week to cut rates underscored the seriousness of the U.S. economic situation.
"The world's stock markets are in meltdown so the Fed came in with an inter-meeting move to try to stop the panic," Christopher Rupkey, senior economist at Bank of Tokyo-Mitsubishi, told the Associated Press.
U.S. Treasury Secretary Henry Paulson said he was confident in the resilience of the U.S. and global economies and welcomed the Fed cut as a helpful move.
"This is very constructive and I think it shows this country and the rest of the world that our central bank is nimble and can move quickly in response to market conditions," Paulson said.
Meanwhile, President Bush won't rule out the possibility of expanding a $150 billion economic stimulus package outlined last week to reinvigorate the ailing economy, the White House said Tuesday.
"I'm not going to close the door, but I'm not suggesting that anyone believes it has to be bigger" than the roughly $150 billion figure already discussed, press secretary Dana Perino told reporters. Later, Perino said that at this point the White House has not "seen higher numbers floated by members of Congress" and that Mr. Bush believes the growth package he has outlined is "the right amount."
Last week, the president put forward the broad outlines of a stimulus plan that would include tax cuts for individuals and businesses. Mr. Bush said any plan, to be effective, would need to represent roughly 1 percent of the gross domestic product, or about $140 billion to $150 billion.
Perino said the White House does not comment on daily fluctuations in the market. But she did say that people should have confidence in the underlying strength and long-term prospects of the U.S. economy.
"We are not forecasting a recession," Perino said. "Clearly there is a slowdown."
Some economists disagreed with that assessment.
"The Fed did something dramatic that was partially anticipated. However, the big picture is that we're either in or headed to a recession," Al Goldman, chief market strategist at A.G. Edwards in St. Louis, told Reuters.