The rate, which is the interest banks charge each other on overnight loans, had already been cut to 1 percent, a level seen only once in the past 50 years, but Tuesday's unprecedented move takes the rate to the lowest on records dating back to 1954.
"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Federal Open Market Committee said today in a statement in Washington. "The committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."
After an upbeat open Tuesday, U.S. stocks rallied on news of the Fed's decision. The Dow Jones industrial average rose 359.61 points, or 4.20 percent, to close at 8,924.14. The Standard & Poor's 500 Index jumped 44.61 points, or 5.14 percent, to 913.18. The Nasdaq Composite Index climbed 81.55 points, or 5.41 percent, to 1,589.89.
"The rate cut was definitely more than a lot of people were expecting and that's really helping the market here. But the big takeaway here is [Fed chief Ben] Bernanke's going back out into the market and trying to loosen things up in credit," Jocelynn Drake, market analyst at Schaeffer's Investment Research in Cincinnati, Ohio, told Reuters.
"We've got a Fed that's willing to really go the distance for the market right now," Drake added.
Before the Fed's announcement, the Labor Department reported there was a record plunge in consumer prices in November, adding to the pressure for the Fed to guard against a dangerous bout of deflation. Prices fell 1.7 percent, surpassing the previous record decline in October at 1 percent.
The drop in overall prices exceeded forecasts by economists, who had expected a 1.2 percent decline, reported Reuters. The report showed inflation rising over the last 12 months by 1.1 percent, the smallest 12-month increase since 2002.
It marked the second straight month that prices dropped, but energy costs nearly doubled the decline of the previous month, the report said. Energy prices fell by 17 percent in November, versus 8.6 percent in October.
After hitting a record high at $147 per barrel in mid-July, crude oil has fallen by $100 per barrel since then. The price of gas at the pump has dropped from $4.11 per gallon this summer to $1.66 in the most recent Energy Department survey.
"Falling energy prices, particularly gasoline, drove the decline in the overall index. Excluding energy, the index was virtually unchanged," the department said of the consumer price index, the Agence France-Presse reported.
The Commerce Department also released data Tuesday showing major declines is new home construction, which dropped 18.9 percent in November. The decline pushed construction to the slowest pace on records dating to 1959.