WASHINGTON — The Federal Reserve offered super-low interest rates for two more years Tuesday – an unprecedented step to arrest an economic free fall that dragged down the stock market. Wall Street roared its approval and finished a wild day with a 429-point gain.

The rally was remarkably fast – the Dow Jones industrial average was still down for the day with less than an hour of trading to go – and enough to erase two-thirds of its decline the day before.

The Fed set its target for interest rates near zero in 2008 as a response to the financial crisis that fall. Since then, it had said only that rates would stay low for an “extended period.” On Tuesday, it said that would be at least through mid-2013.

But the Fed also said it expects the economy to stay weak for two more years, longer than the Fed had previously indicated. It has already been more than two years since the end of the Great Recession.

The central bank left open the possibility of a third round of bond purchases designed to hold interest rates down and push stock prices up. The second round, announced last year, sparked a 28 percent rally in the Dow through April 29.

What little confidence consumers have is being undermined by the Wall Street tumult.

Americans struggling with lean wages and job insecurity have seen their 401(k) accounts shrivel over the past two weeks. A plunge in oil prices has provided some relief at the pump, but not enough to ameliorate anxiety about the overall economy.

When consumers feel less wealthy, they’re less likely to buy new furniture, new appliances or new cars. And because their spending drives about 70 percent of the economy, analysts fear a negative feedback loop in which markets and consumers drag each other down.

“We’ll just scare ourselves into a recession,” says David Kelly, chief market strategist with J.P. Morgan Funds.

The drop in the stock market could cut overall spending by $140 billion, or 1.3 percent, over the coming year, says Paul Dales, senior U.S. economist at Capital Economics. Dales forecasts that the stock market turmoil could reduce the economy’s annual growth rate by half a percentage point through 2012.

There isn’t much to spare. In the first half of the year, the economy grew at a scant 0.8 percent annual rate. That helps explain the dive on Wall Street: Stocks are falling partly on fears that the nation could slip back into a recession.

Tuesday was an unusually volatile day of trading. The Dow was up about 200 points most of the morning. It was up about 100 when the Fed statement came out at 2:15 p.m. Within half an hour, the Dow was down more than 200.

But investors warmed to the Fed news, and the Dow made a bumpy, steep climb for the final stretch of trading. That included a 640-point swing from its lowest point of the day to its highest.

In Europe, efforts by the European Central Bank to contain the continent’s debt crisis made progress on Tuesday. For the second day in a row, the rates that Italy and Spain pay to borrow money fell. The ECB began buying debt of the two countries this week to keep them from succumbing to the same financial contagion that has infected Greece, Ireland and Portugal.

European stock exchanges were mostly up Tuesday, with the British market up 1.9 percent, the French up 1.6 percent, and the Italian up 0.5 percent. The exceptions were the German stock market, which was down 0.1 percent, and the Spanish, down 0.4 percent.

Asian markets opened sharply higher early today, with Japan’s blue-chip Nikkei-225 index up 1.9 percent.

The yield on the 10-year Treasury bond briefly hit a record low, 2.03 percent, and finished at 2.26 percent. Investors have bought U.S. debt, driving yields down, even after S&P stripped the United States of its top-of-the-line credit rating last week.

Interest rates on consumer loans, including adjustable-rate mortgages, car loans and credit cards, are often based on Treasury rates. So mortgage rates, which are already among the lowest ever, could go even lower.

Low interest rates for two more years could make the stock market a better bet because bonds will return less money. That appeared to be at least part of the reason stocks rallied so much after investors had a chance to digest the Fed’s statement.

Some analysts also attributed the late-day rally to wording in the Fed’s statement suggesting it might take further steps to stimulate the economy in the future.

The stock rally came after two and a half weeks of almost uninterrupted declines. Those were fueled first by uncertainty about the federal debt ceiling, then by concerns that the U.S. economy is headed for a new recession and about out-of-control European debt.

When it came late Friday, the downgrade only added anxiety. On Monday, the first day of trading after it was announced, the Dow fell 634 points. Even counting Tuesday’s gains, the Dow is down 11.6 percent since July 21 – almost 1,500 points.

The price of gold continued its seemingly unstoppable climb. It set a record price of $1,782 an ounce. Some investors see gold as a safe bet because its value isn’t tied to a particular nation, like a currency or government bonds, or to companies, like stocks. The price of gold has more than doubled since the recession began in 2007.

The Fed’s announcement of a two-year time frame for any rate increase underscored a stark reality: A sluggish economy and painfully high unemployment have become chronic.

“The tone of the Fed’s statement is very downbeat. They are very nervous about the economy,” said Mark Zandi, chief economist at Moody’s Analytics. “This is unprecedented for the Fed to indicate they are ready to keep rates low for two more years.”

Not everyone was as impressed as investors on Wall Street appeared to be. University of Oregon economist Timothy Duy called the move “weak medicine” and said he wanted to see the Fed commit to buying more Treasury bonds, a measure known as quantitative easing.

The Fed’s projection of a weak economy into 2013 is also bad news for President Obama, who must fight a re-election campaign next year. Already, some of Obama’s Republican challengers have blamed the S&P downgrade on him. S&P itself blamed the country’s long-term debt problems and dysfunctional politics.

Specifically, the Fed said the economy was “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” It held out the promise of further help down the road but did not spell out what else it might do.

The central bank’s decision was approved on a 7-3 vote with three Fed regional bank presidents who have been worried about inflation objecting. It was the first time since November 1992 that as many as three Fed members have dissented from a policy statement.

Dean Maki, chief U.S. economist at Barclays Capital, said the dissent suggests Fed Chairman Ben Bernanke would have trouble building consensus for more bond purchases.

 

The Washington Post contributed to this report