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NEW YORK (Reuters) - The U.S. Federal Reserve took a radical step to revive the moribund economy, slashing its key interest rate to zero to 0.25 percent on Tuesday, shortly after plummeting consumer prices and record-low housing starts pointed to a prolonged recession.
Markets rallied on news of the larger-than-expected cut from 1 percent, which virtually exhausts the traditional Fed tools to battle the year-long recession.
The Fed, which said it would employ "all available tools," might take a page out of Japan's economic playbook. Japan's Central Bank signalled it could flood banks with zero-interest money for the second time in a decade. Japan might also see a rate cut this week, and in Europe, new data pointed to a possible cut next month.
U.S. stocks closed 5 percent higher after what one investor called the "extremely bold" Fed move. U.S. Treasury debt rallied sharply, pushing the benchmark note's yield down to five-decade lows, and the U.S. dollar tumbled versus the Euro and yen.
"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."
The extent of the current turmoil was all too apparent when Wall Street titan Goldman Sachs Group posted its first quarterly loss since going public nine years ago.
But the fourth-quarter net loss of $2.12 billion (1.4 billion pounds) was less than the market feared and Goldman shares shot up more than 16 percent after losing 70 percent this year.
Another U.S. heavyweight, General Electric, also allayed fears of a catastrophic 2009 at the conglomerate with its announcement that profit at its industrial units would be flat to 5 percent higher. Shares rose nearly 6 percent.
The U.S. housing market, at the root of the global financial and economic crisis, showed new housing starts and permits each plunging nearly 50 percent in November from a year earlier to record lows.
The U.S. consumer price index also fell at a record rate for a second-straight month during November.
"I think we're in a deflationary spiral that will probably go on until sometime next year," said Thomas di Galoma, head of U.S. Treasury trading at Jefferies & Co. in New York. "I think it will probably go on through the majority of 2009."
President-elect Barack Obama said that, with traditional Fed tools running out, it was important for the rest of government to pull together an economic recovery plan.
In Japan, where rates are already at an ultra-low 0.3 percent, the finance minister urged the central bank to take unorthodox steps to ease a funding crunch.
Bank of Japan Governor Masaaki Shirakawa said he was studying possible effects of so-called quantitative easing, or flooding banks with zero-interest money. Japan used that approach early this decade to spur lending and jump-start a stagnant economy.
Analysts are also debating whether the biggest plunge in business confidence in three decades will prompt the Bank of Japan to lower rates again when it meets this week.
Europe also presented evidence that an interest rate cut could take place next month. Manufacturing and services activity in the euro single-currency area sank to new lows in December, a survey showed, pointing to a deepening recession.
European car sales dropped by a quarter in November and manufacturers scaled back production.
As the impact of the sagging U.S. auto industry spread around the world, investors hoped to see the Bush administration approve loans for carmakers with funds from the bank rescue bailout.
President George W. Bush told CNN his administration was trying to get the lifeline sealed "in an expeditious way," but White House spokeswoman Dana Perino said, "We're not going to be rushed into it."
"The automakers will get the money as quickly as we can prudently do it," Treasury Secretary Henry Paulson said in an interview on CNBC television. "We need to do this but we need to do it right."
Moreover, a top Treasury official, David McCormick, told CNBC the $700 billion Troubled Asset Relief Program was meant to shore up the financial sector, not the car companies.
Wednesday promises major news on the oil front, as OPEC meets in Algeria and top producers Saudi Arabia and Iran give full backing to remove up to 2 million barrels per day of supply to address the first drop in world oil demand in 25 years.
But prospects of the biggest oil supply cut ever did little to help oil prices, which have plunged $100 from their all-time high in July because of slumping demand. On Tuesday, they fell more than 3 percent as the slowing economy outweighed any optimism over the OPEC and Fed moves.
"The fact that the Fed cut rates by 75 basis points rather than the consensus of 50 points seems to indicate that perhaps the economy needs major, major overhaul that is bigger than expected earlier," said Nauman Barakat, senior vice president at Macquarie Futures USA.
"That translates into lower demand for crude oil."
Nearly a week before Christmas and amid a spate of negative news in the retail sector, top U.S. consumer electronics retailer Best Buy posted a higher-than-expected quarterly profit.
Best Buy also said it plans to offer buyouts and trim back store openings as consumers cut spending. Its shares rose nearly 17 percent.
The U.S. stocks rally pushed the benchmark S&P 500 index to its highest close since November 10, up 5.14 percent to 913.18.
U.S. government debt yields slipped to historic lows. The price on 30-year Treasury bonds rose sharply, pushing its yield to lows below 2.89 percent. The benchmark 10-year Treasury note's yield fell to below 2.44 percent. Both rates were last seen in the 1950s.
Earlier in the day, European stocks closed higher on Goldman and Fed rate-cut expectations. Japanese shares fell 1.1 percent as the yen's strength against the dollar hurt shares of exporters.
Reporting by Reuters bureaus worldwide; Writing by Mary Milliken; Editing by Brian Moss, Gary Hill