Paulson: cut rates to head off US slump

While he refused to use "the R word" - recession - it was his strongest language yet to describe the current weakness.

Analysts said he was sending a clear message to Fed Governor Ben Bernanke not to hold back on tonight's rates move. He is widely expected to cut rates by a percentage point to 2% in what would be the biggest reduction in borrowing costs since 1984.

"We know we're in a sharp down-climb and there's no doubt the American people know that the economy has turned down sharply," said Paulson, adding that he was confident Wall Street's capital markets would thaw out.

He was speaking as global stock markets rallied after Goldman Sachs and Lehman Brothers posted first-quarter profits that were less weak than expected.

The FTSE 100 index raced up 127.5 points to 5541.9 but dealers admitted there would be further big falls if more bad news emerged. The Footsie crashed more than 200 points yesterday as panic and fear spread through trading rooms.

Shares of Goldman and Lehman bounced back from heavy losses yesterday as did MF Global, the US trading division of London hedge fund manager Man Group.

Former Fed Governor Lyle Gramley, now of Stanford Group in Washington, said: "The Fed has moved very aggressively to deal with liquidity problems that are major. They need to be aggressive on the monetary policy side. This is the worst crisis we have faced in more than 50 years."

Mark Cliffe, chief economist at ING in London, said the Fed could follow the Japanese road to zero interest rates. He added: "We now look for Fed funds to be cut to 1%, taking the dollar lower in the process. Further systemic shocks raise the possibility of Fed funds hitting zero."

The dollar has tumbled to record lows against a host of currencies this year as recession bites. It has been joined on the slide by sterling. The Fed has already reduced interest rates from 5.25% to 3% and pumped billions of dollars of emergency funding into the markets but it has done little to restore confidence or calm.

Fears are growing that the Fed and other central banks are powerless to solve the crisis. Critics warned a full percentage-point cut would leave the Fed very little room to move again if it gets worse.