(Updates with rate decision, changes byline)
By Mark Felsenthal
WASHINGTON, Dec 16 (Reuters) - The U.S. Federal Reserve on Tuesday aggressively cut its target for overnight interest rates to a record low zero to 0.25 percent, and said it would employ "all available tools" to dispel a year-long recession.
The surprise move to lower its target for the benchmark federal funds rate by 0.75 percentage points to up to a full point from its prior 1 percent put the Fed in unprecedented policy territory. Financial markets had expected the Fed to lower rates by no more than three-quarters of a point.
"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Fed said.
The cut in the federal funds rate pushes it to its lowest level on records dating to July 1954, and the central bank said it would likely keep it at "exceptionally low levels for some time."
In addition to the rate cut, the Fed said it was prepared to expand already announced large purchases of debt issued by government-sponsored mortgage agencies to support the battered U.S. housing market. It also said it was mulling possible purchases of longer-term government debt and would consider other ways to tap its balance sheet to support the economy.
Prices for U.S. stocks and government debt shot higher, while the dollar slipped, on the Fed's announcement.
"It's a highly unorthodox and creative step," said Michael Woolfolk, senior currency strategist, at the Bank of New York-Mellon in New York. "We think it's the best possible move for the U.S. consumer and for the financial market."
OPENING FRESH FRONT IN CRISIS
U.S. authorities have been unable to prevent the recession from deepening despite a range of unprecedented initiatives designed to encourage lending by loss-scarred banks. They stepped up their actions after the failure of investment bank Lehman Brothers in September intensified the financial turmoil.
In addition to rate cuts, the Fed has pumped massive amounts of money into credit markets, pushing the size of its balance sheet to $2.2 trillion.
Stark evidence of how hard the long-running financial crisis has slammed the economy came on Dec. 5 in a report showing employers shed 533,000 jobs in November, the most in 34 years. The unemployment rate hit a 15-year high of 6.7 percent.
Economists polled by Reuters last week expected the economy to contract at an annualized 4.3 percent in the last three months of the year, and to continue to shrink through the first six months of 2009.
Grim data since then has led many economists to look for an even deeper contraction, with some expecting output to fall at more than a 6 percent pace in the fourth quarter.
Fresh confirmation of the downturn came earlier on Tuesday with data showing construction starts on new homes slumping to a record low and consumer prices tumbling by a record amount.
The drop in prices has raised the specter of the kind of damaging deflationary spiral that consigned Japan to a decade of stagnation in the 1990s. In the current U.S episode, however, the type of broad-based price declines that typify a deflation are absent.
Aware it was exhausting its ability to stimulate the economy by lowering interest rates, the Fed started its meeting on Monday -- a day earlier than initially scheduled -- so policy-makers could discuss their options.
In a speech on Dec. 1, Fed Chairman Ben Bernanke laid out a menu of alternative policies the central bank could pursue to lift the economy with little room to cut rates further.
"Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver -- the provision of liquidity -- remains effective," he said. (Additional reporting by Alister Bull)