As expected, the US Federal Reserve cut the Fed funds interest rate by 25 basis points, from 4.5 per cent to 4.25 per cent on Tuesday 11 December. Only, investors were looking for an even bigger cut, and dumped American stocks following the announcement, causing the markets to fall.

The Federal Reserve lowered its federal funds target rate - which governs overnight lending between commercial banks - by 25 basis points, from 4.50 per cent to 4.25 per cent. The Fed had previously cut the rate by 50 basis points on 30 September and 25 points on 31 October.

The Federal Reserve also cut its discount rate - the rate at which banks can borrow directly from the Fed - by 25 basis points, from 5 per cent to 4.75 per cent. Financial markets had generally expected a 25 basis points Fed funds rate cut, though some did forecast a steeper cut, to a 4 per cent Fed funds rate.

But a somewhat larger number expected a 50 basis points cut in the discount rate. The central bank policymakers apparently did not feel that either step was necessary. The equity markets slid after the less-than-hoped-for cut. The Dow Jones industrial average closed down 2.1 per cent or 294 points, to 13,433. The tech-led Nasdaq was down 2.45 per cent or 67 points, to 2,652.

Interest rates fell sharply in the government bonds market, with the yield on the benchmark 10-year Treasury bonds sliding to 3.97 per cent from 4.15 per cent on Monday evening.

The central bank said, "Economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time." Obviously, the market didn't agree.

While falling interest rates reduce borrowing costs for people and companies, and in that way provide an economist boost, a rate cut isn't without its costs. Interest rate cuts tend to encourage inflation at a time when consumers are already feeling the strain from rising food and energy prices.

They also put pressure on an already-weak dollar, which has lost 10.2 per cent against the euro in the past year. But, to be fair, it's not just the declining interest rates; the huge US trade deficit has played a large role in dragging the dollar down.

Wall Street had also expected a larger rate cut because central bankers, including Fed chairman Ben Bernanke, have openly expressed dissatisfaction with US economic performance. Federal Reserve Governor Janet Yellen said earlier this month that she expects "very meagre" fourth-quarter growth.

The US economy is feeling multiple strains. Despite the Fed's attempts to push interest rates lower, loan costs have actually risen for many borrowers because lenders, wary of risk, are restricting lending. The slowing US economy also means that companies and individuals tend to spend less, sharply eroding consumer confidence.

But the real bogeyman here is the fear that the US is heading toward a recession. Morgan Stanley's chief US economist Dick Berner and chief US fixed income economist David Greenlaw both said on Monday that a mild recession is not only possible, but also probable.

They predict that gross domestic product (GDP) growth will stop from now till the third quarter of next year, and that corporate earnings may contract by up to 10 per cent over that period.

A continuing decline in economic conditions would force the Fed to cut rates further in January. Even on Tuesday, the Fed was far from unanimous in its view. Boston Federal Reserve president Eric S Rosengren dissented against the 25 basis point cut decision. He preferred to lower the Fed funds target rate by 50 basis points.