The US Federal Reserve yesterday nudged interest rates lower for the first time in nearly three years in response to the deepening international financial crisis.

The central bank's open market committee reduced the target for its Federal funds rate - its main lending rate - by a quarter of one per cent to 5.25 per cent.

The Fed said the action had been taken "to cushion the effects on prospective economic growth in the United States of increasing weakness in foreign economies". It added that policy-makers were concerned about tightening credit conditions in the United States.

The cut marked a shift in Fed policy for the first time in a year. Interest rates were last changed in March 1997, when the central bank raised the Fed funds rate in a pre-emptive strike against inflationary pressures. The last time the Fed lowered rates was in early 1996.

US stocks initially reacted negatively to the news, while bond prices rose. Investors had been hoping for a bigger cut in recognition of the severity of the global economic crisis. The Dow Jones Industrial Average was down about 60 points on the day about an hour before the close. It closed down 28.32 at 8080.52 last night. But a bigger interest rate move would have been out of line with past practice and might have signalled to the markets that policymakers had become alarmed about international economic conditions. When the Fed has changed the direction of its policy in the last few years it has tended to take it slowly, with just a quarter-point move.

Another factor that restrained the Fed was the solid growth of the US economy. In the first six months of 1998, the economy expanded at an annual rate of more than 3 per cent, comfortably above what most economists regard as a sustainable pace. In the last few months, the pace seems to have cooled as international conditions have deteriorated but output continues to expand.

A cut in short-term interest rates had been widely expected following strong hints last week by Alan Greenspan, the Fed chairman, that the international turmoil was placing greater pressure than ever on US financial markets.

Yesterday the latest sign of weaker economic conditions emerged with a report that indicated consumer confidence fell sharply this month. The Conference Board, an independent research group, said its main index of confidence fell by seven points in September, the largest one-month drop since January.

In Europe, the Fed's move will put pressure on Italy, Spain, Portugal and Ireland to cut their short-term rates to the level of France and Germany, 3.3 per cent, but the governing council of Germany's Bundesbank is expected to leave interest rates unchanged at its regular meeting tomorrow.

A senior German central banker hinted this week the European Central Bank might have to cut interest rates next year, if the uncertainty in international financial markets persists.