In an indication that the Federal Reserve sees an increased risk of recession, a committee that sets monetary policy cut two key short-term interest rates today by half a percentage point.

The Federal Open Market Committee’s decision to slash its target for the federal funds overnight rate to 3 percent, and the discount rate to 3.5 percent, was not unexpected.

But coming on the heels of an unscheduled 75-basis-point cut in both rates Jan. 22, the 1.25 percent reduction the Fed has undertaken in just eight days surpasses short-term interest-rate cuts made in all of 2007.

“Financial markets remain under considerable stress, and credit has tightened further for some businesses and households,” members of the committee said in a statement. “Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.”

After the breakdown of credit markets in August, the Fed cut 50 basis points off the federal funds and discount rates. Those reductions were followed by 25-basis-point reductions in both rates on Oct. 31 and Dec. 11.

With today’s action, the Fed has reduced its target for the federal funds rate from 5.25 percent, where it had stood since 2006, by 2.25 percent.

The federal funds rate is the rate banks charge each other for overnight loans, which the Fed can influence by easing or constricting the supply of money. The discount rate — what the Federal Reserve charges banks for short-term loans — is set directly by the Fed.

Slashing short-term interest rates can stimulate economic growth by reducing the cost of borrowing, and also provides relief for holders of adjustable-rate mortgages tied to the federal funds rate.

The Dow Jones Industrial Average initially soared 200 points in reaction to today’s decision to cut short-term rates again for the second time in little more than a week.

But some critics have said that lowering short-term rates could create inflationary pressures, and send long-term rates — like those for 30-year-fixed mortgages — in the other direction.

Only one of the committee’s 10 members opposed today’s decision to cut the target for the federal funds rate by 50 basis points. Member Richard W. Fisher advocated no change in the target for the federal funds rate.

Reducing the discount rate is intended to provide liquidity to strapped credit markets. But because of the stigma attached to borrowing at the discount window, banks have been reluctant to do so. The Federal Reserve also made $60 billion in short-term funding available to banks through two auctions this month, a practice that it plans to continue as needed (see Inman News story).

Congress and the Bush administration are also working out the details of a proposed economic stimulus package that would provide $150 billion in tax rebates and incentives, and raise the conforming loan limit in high-cost markets to $729,750, or 125 percent of the median home price, whichever is less (see story).

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