"It's in keeping with the volatility we've seen in the last couple of weeks, particularly in recent days," said Mike Malone, trading analyst at Cowen & Co.
After heading lower in the immediate aftermath of the central bank's move, the Dow Jones Industrial Average closed 35.5 points ahead at 13,504.3, with 22 of its 30 components on the rise.
"I think the reaction to the downside was an over-reaction given the Fed commentary was largely in line with expectations; they addressed recent concerns in regard to the credit market, but didn't commit to providing additional liquidity down the road," said Malone.
The S&P 500 gained 8.93 points to 1,476.60, while the Nasdaq Composite was 14.27 points ahead at 2,561.60.
Trading volume showed 2.2 billion shares exchanging hands at the New York Stock Exchange and 2.7 billion shares trading on the Nasdaq stock market.
Advancing issues beat declining stocks by a 9 to 7 ratio on the NYSE and by 17 to 13 on the Nasdaq.
"If you went back, the first move is always the wrong move; the last nine initial moves have reversed, it's the way the news is disseminated," said Art Hogan, chief market strategist at Jefferies & Co. Stock prices dropped in response to the initial headlines, which stressed the Fed's decision to let interest rates stand and that inflation remains the Fed's main worry.
But, once the market had time to read through the Fed's statement in full, the central bank in fact is "leaning in the direction of 'hey, we're here if things get worse,' it brings the balance back to neutral," said Hogan.
As expected, the central bank left the key overnight rate at 5.25% for the ninth straight meeting, while repeating the risk that inflation will fail to moderate is the "predominant policy concern."
Many investors had expected recent problems in the credit markets would force the Fed to note concern about an economic slowdown in its policy statement. For many months the Fed's top worry has been inflation.
Such a change in stance could pave the way for a rate cut in coming months.
"The initial reaction was clearly negative, and the reason is because the Federal Reserve did not go far enough in the view of investors in focusing its concern on credit market conditions and the impact on the economy," said Hugh Johnson, chairman of Johnson Illington Advisors.
"The Fed left the markets to heal themselves, a risky gambit in an environment where the credit markets, which in the modern age exert substantially more influence on the economy on decades past, is dysfunctional," said Tony Crescenzi, an analyst at Miller Tabak & Co. LLC.
Earlier, the Labor Department reported that productivity in the second quarter rose 1.8%, below the 2.1% gain expected by economists polled by MarketWatch.
The wages and benefits component of the report suggested inflation may remain worrisome. The department said that unit labor costs - a key inflationary signal - rose at an annual rate of 2.1% in the second quarter. Economists had expected a 1.6% gain.
Automaker General Motors Corp. fronted the Dow's advancing stocks, gained 1.4% after GM said it completed the sale of its Allison Transmission commercial and military business to the Carlyle Group and Onex Corp. for about $5.6 billion.
Shares of leading U.S. banks and brokerage firms gained, with the stock of insurer Assurant Inc. up 4.2% after analysts at Merrill Lynch upgraded Assurant to buy.
Bear Stearns Cos. was off 0.2%. Bloomberg News reported the company's decision to liquidate two bankrupt hedge funds in the Cayman Islands instead of New York might limit creditors' and investors' ability tget their money back.
Lehman Bros. analysts began coverage of private-equity and hedge fund Blackstone Group , giving it an overweight rating. Blackstone's shares gained 0.5%.
Luminent Mortgage Capital Inc. was cut to sell from neutral by UBS. Its stock was off about 82%. The lender suspended its quarterly dividend and said it would explore options including a sale.
Other market moves
The benchmark 10-year Treasury note closed unchanged at 98 4/32, yielding 4.740%.
The dollar rallied against the euro and fell modestly against the yen in the wake of the Fed's interest-rate announcement. In New York trade, the dollar was quoted at 118.34 yen, compared with 119.03 yen late Monday. The euro traded at $1.3747 vs. $1.3755 before the Fed's statement. The dollar was at 118.50 yen vs. 118.46 before the new.
Gold futures closed with a slight loss shortly before the Fed made its move, with gold for December delivery ending $1 lower at $682.30 an ounce on the New York Mercantile Exchange.
Crude-oil futures were higher, with crude oil for September delivery up 14 cents to $72.20 a barrel on the New York Mercantile Exchange.
On Monday stocks staged a strong comeback, after suffering a rout at the end of last week when investors dumped shares on fears the credit crunch is spreading throughout the economy.
By Kate Gibson