WASHINGTON (Reuters) - The US Federal Reserve yesterday entered uncharted policy territory as it chopped its benchmark interest rates to as low as zero and pledged to use "all available tools" to turn back a deepening recession.

In a surprise and historic move, it lowered its target for the benchmark federal funds rate to a range of zero to 0.25 percent, a record low, from 1.0 percent, and said it was willing to keep rates low for an extended period.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability," the Fed said.

In addition to the rate cut, the Fed said it was prepared to expand a plan to purchase large amounts of debt issued or guaranteed by government-sponsored mortgage agencies. It also said it was mulling possible purchases of longer-term US Treasury debt and would consider other ways to tap its burgeoning balance sheet to support the economy.

"The focus of the committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level," it said.

The Fed's announcement spurred a big rally in US stocks, with the blue chip Dow Jones industrial average closing up 359 points, or 4.2 percent. Prices for US government debt also shot higher, pushing yields to record lows, while the US dollar fell to a fresh two-and-a-half month low against the euro.

"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 US consumer and for the financial market."

Financial markets had expected the Fed to lower rates by no more than three-quarters of a point.

US authorities have been unable to prevent the recession from deepening despite a range of unprecedented initiatives designed to encourage lending by loss-scarred banks. They stepped up their actions after the failure of investment bank Lehman Brothers in September intensified the financial turmoil.

In addition to rate cuts, the Fed has pumped massive amounts of money into credit markets, pushing the size of its balance sheet to $2.2 trillion from $887 billion over the last three months.

The rapid expansion in the Fed's balance sheet amounts to a form of "quantitative easing", a policy pursued by Japan earlier this decade to expand the supply and circulation of money after it was forced to lower rates to zero.

Japan, however, pumped excess reserves into the banking system to try to jump-start lending. In the Fed's case, officials are trying to circumvent lending-wary banks and target specific markets where credit is jammed.