The Fed — which had resisted lowering rates despite weeks of market volatility, and instead added nearly $120 billion in liquidity into the banking system — cut its discount rate to 5.75 percent from 6.25 percent. The central bank acknowledged that the stock market turbulence that has pulled the Dow by hundreds of points a day was posing a risk to economic growth.
"People were kind of baiting the Fed into doing something, and finally they did," said Philip Dow, managing director of equity trading at RBC Dain Rauscher. "The playground monitor finally showed up, and it showed someone cares and someone is bringing rationality into the market."
But the central bank made no mention of lowering its target for the federal funds rate, which has stood at 5.25 percent for more than a year. The fed funds rate determines the rates that banks charge each other, while the discount rate only covers loans the Fed makes to banks. Many strategists believe the market won't settle down until the Fed lowers the fed funds rate target, considered a more significant benchmark.
If the market doesn't get that rate cut, Friday's gains may not stick, especially since it's likely there will be plenty more news in the coming days and weeks of further troubles in the lending industry. Any mention of problems at subprime lenders or funds that invested in mortgages has sent stocks skidding, and so have worries that tighter credit will stanch the flood of takeovers, which sent Wall Street to new highs earlier this year.
Still, the Fed made it clear this wasn't the only step it would take if the volatility continued. In its statement, the Fed said it "is prepared to act as needed."
According to preliminary calculations, the Dow Jones industrial average surged 233.30, or 1.82 percent, to 13,079.08.
Since its midday low on Thursday, the Dow has recovered more than 500 points, reports CBS News correspondent Anthony Mason. All three major indexes—the Dow, the NASDAQ and the S&P 500—are back in the plus column for the year.
Trading was still volatile throughout the day, with the Dow rising more than 320 points in early trading, giving up more than half those gains, and then gaining steam once more. However, the blue chip index stayed in positive territory the whole time. The Dow is more than 6 percent below its record close of 14,000.41 reached July 19, and fell more than 1 percent for the week.
The Standard & Poor's 500 index rose 34.65, or 2.46 percent, to 1,445.92, and the Nasdaq composite index rose 53.96, or 2.20 percent, to 2,505.03.
Bonds slipped as stocks rose, with the yield on the benchmark 10-year Treasury note rising to 4.67 percent from 4.66 percent late Thursday.
Traders who bet on how the Fed might alter rates expect the central bank will lower the benchmark fed funds rate at its next meeting on Sept. 18. Some investors are hoping for a cut in that benchmark rate even sooner.
"If the cut in the discount rate succeeds in restoring confidence, then perhaps there is no need for the Fed to cut rates at the Sept. 18 meeting," said John Lonski, chief economist of Moody's Investor Service. He added, though, that the key line in the Fed's statement Friday was its willingness to take more steps to prevent market volatility from harming the economy.
"That means the Fed is prepared to make a rate cut if stability doesn't come," Lonski said.
Gains were seen in all sectors of the stock market, but financial stocks, which have been battered by the growing problems in mortgage lending, saw particularly heavy buying. Dow component JPMorgan Chase & Co. rose 3.4 percent, while Merrill Lynch and Lehman Brothers rose more than 6 percent.
The pummeled stocks of mortgage lenders also saw significant increases. The most actively traded stock on the New York Stock Exchange, and one of its biggest percentage gainers, was Countrywide Financial Corp. The home mortgage lender rose $2.48, or 13.1 percent, to $21.43.
Energy and industrial companies also strengthened notably. The biggest gainers among the 30 Dow companies were aluminum producer Alcoa Inc. and oil company Exxon Mobil Corp., which both jumped more than 4 percent.
Major European indexes recovered substantially after the Fed's announcement from steep declines in earlier trading. Britain's FTSE 100 rose 3.50 percent, Germany's DAX index rose 1.49 percent, and France's CAC-40 rose 1.86 percent.
In Asian trading, which closed before the Fed lowered the discount rate, Japan's Nikkei stock average had plunged 5.42 percent as the yen continued its climb against the dollar. The dollar briefly dipped below 112 yen for the first time in over a year, suggesting that some investors were taking their Japanese currency out of higher-yielding dollar assets.
The dollar was mixed against other major currencies. Gold prices jumped.
Advancing issues outnumbered decliners by about 7 to 1 on the New York Stock Exchange, where volume came to 2.48 billion shares, down from 2.92 billion shares.
The Russell 2000 index of smaller companies added 17.20, or 2.24 percent, to 786.03.
Crude oil futures rose 98 cents to $71.98 a barrel. Traders have been tracking the path of Hurricane Dean, which is threatening to head west into the Gulf of Mexico, where many oil installations are located.