NEW YORK (Bloomberg) — Federal Reserve policy makers, who declared that inflation was their paramount challenge just two weeks ago, have been forced to make financial-market stability the trigger for changes in interest rates.

By lowering the discount rate and issuing a statement conceding threats to the economy, Federal Open Market Committee members effectively ripped up the economic-outlook statement from their August 7 meeting. Some economists describe the about-face, coming after months of assurances that the subprime-mortgage rout was contained, as Chairman Ben Bernanke's first serious error since taking office last year.

"It was a rookie mistake," said Kenneth Thomas, a finance professor at the University of Pennsylvania's Wharton School in Philadelphia. The Fed "underestimated liquidity needs" of investors and the fallout from the housing recession, he said, adding, "This demonstrates the difference between book-smart and street-smart."

Bernanke, a former chairman of the economics department at Princeton University, has elevated the role of forecasts in Fed policy rather than amassing clues from dozens of market indicators as predecessor Alan Greenspan did. The Fed forecasts showed that "moderate" growth would continue, and that inflation remained the biggest danger. The credit collapse has undermined that stance, and Bernanke may cut the benchmark interest rate by at least a quarter-point at or before the September 18 FOMC meeting, analysts say.

"Sometimes, the dynamics change very, very quickly," said former Fed governor Laurence Meyer, who voted for the three reductions in 1998 after currencies in Asia, Russia and Latin America tumbled. Bernanke's shift "tells us how difficult it is to translate financial turbulence into the macroeconomic forecast."

The Fed on August 17 lowered its discount rate — what it charges banks for direct loans — by 0.5 percentage point to 5.75 percent, in an effort to increase liquidity in longer-term loans and bonds.

The initial request for the move came from Fed district banks in New York and San Francisco. They are led respectively by Timothy Geithner and Janet Yellen, both former Clinton administration officials who dealt with the 1997-1998 currency crises. The Fed's Board of Governors in Washington is dominated by academics.

Meyer, vice chairman of Macroeconomic Advisors LLC in Washington, recommended prior to the August 7 FOMC meeting that policy makers cease describing inflation as the biggest risk. By saying the risks to growth and inflation were roughly equal, the central bank would have given itself room to maneuver if markets — already weakening — continued to slide.

The committee said in its statement three days ago that "the downside risks to growth have increased appreciably" because of the tumult in markets. Officials abandoned the prediction of a "moderate" expansion, and inflation wasn't mentioned.

While leaving the main rate at 5.25 percent, the panel said it is "prepared to act as needed to mitigate the adverse effects on the economy."

Stocks rallied after the announcement, but credit markets remained unsettled. The Standard & Poor's 500 Index climbed 2.5 percent, the biggest rally in four years. By contrast, asset-backed commercial paper yields jumped the most since the September 11, 2001, terrorist attacks. Top-rated paper maturing August 20 yielded 5.99 percent late on August 17, up 39 basis points in a day. A basis point is 0.01 percentage point.

"The Fed has an easing bias, but it is not an easing bias dictated strictly by economic conditions," said Stephen Stanley, chief economist at RBS Greenwich Capital Markets in Greenwich, Connecticut. "This is a financial-market issue, which is then bleeding into the economy."

Last week's policy shift notwithstanding, Bernanke's moves to resolve the credit crunch so far have been restrained. Even then, and unlike the Greenspan era, it was the Fed doing the talking, not any one individual.

The Fed pumped $38 billion into the banking system on August 10 to free up financing in short-term credit markets, and issued a six-line statement. The injection was the Fed's biggest since the meltdown began. By contrast, the European Central Bank added $130 billion in temporary reserves a day earlier. ECB President Jean-Claude Trichet followed up with media interviews designed to reassure investors.

"We're getting a nice further look at the new Bernanke Fed," said Ethan Harris, chief US economist at Lehman Brothers Holdings in New York. "He definitely wants to use the committee and these more formal directives," as opposed to Greenspan's preference for speeches laden with "code words."

The reduction in the discount rate, which is used less than the federal funds rate as a policy-making tool, wasn't directed at the broad economy so much as at trying to ease gridlock in credit markets. The Fed said it would accept everything from home-equity loans to municipal bonds as collateral for discount- window loans up to 30 days.

The decision to keep the benchmark overnight lending rate unchanged — for now — may be a sign that the central bank is still wary of bailing out bad bets by financial institutions and investors. St. Louis Fed President William Poole said in an interview on August 15.