WASHINGTON (Reuters) - The Federal Reserve on Wednesday vowed to pump an additional $1 trillion into the U.S. economy in an aggressive bid to battle a deep recession, partly by buying government bonds for the first time since the 1960s.

Concluding a two-day policy meeting, the central bank said it would buy up to $300 billion in longer-term Treasuries to bring down borrowing costs, harkening back to a program called “Operation Twist” that ran from 1961 to 1965.

The decision caught many off guard and jolted markets.

While the Fed had said it was considering such a move, it had downplayed it in recent weeks. As recently as March 6, New York Federal Reserve Bank President William Dudley had said buying longer-term government debt was not the most efficient way to ease credit market strains.

The price of U.S. government bonds surged after the announcement, with yields taking their biggest one-day tumble since 1987. Stock prices also shot higher, while the dollar plunged.

“It’s an attempt to keep rates low, particularly on the mortgage side, which is seen as critical to a big revival of the housing market,” said Rick Meckler, president of Libertyview Capital Management in New York.

“I think it fits in well with the overall plan the government has to be more creative about how it can bring mortgages more in line with the movement that’s appeared in Treasury rates,” he said.

In addition to purchasing Treasury debt, the Fed said it would expand an existing program to buy debt and securities issued by mortgage finance agencies by $850 billion to $1.45 trillion, an effort to lower mortgage rates.

Quicken Loans said rates on 30-year mortgages fell as much as 0.375 percentage point to 5.0 percent on the announcement.

RATES NEAR ZERO

The Bank of England’s recent success in driving interest rates down by buying government debt may have been a factor in the U.S. central bank’s decision. By driving down yields on benchmark debt, the Fed hopes to lower a wide array of credit costs for consumers and businesses.

“This is a pretty dramatic move ... They are trying to bring down all consumer rates,” said James Caron, head of global rates research at Morgan Stanley in New York.

The New York Fed said it would begin buying the Treasury debt late next week and planned to focus on securities with maturities ranging from two years to ten years. It said it would make purchases about two to three times a week.

Morning commuters drive past the Federal Reserve Bank building in Washington March 18, 2009. REUTERS/Jonathan Ernst

In addition to ramping up its efforts to pump money into the recession-struck economy, the Fed unanimously decided to hold its target for overnight interest rates in a zero to 0.25 percent range -- the level reached in December. One Fed official, Richmond Federal Reserve Bank President Jeffrey Lacker, returned to the fold after dissenting in January.

The Fed said rates would stay low for “an extended period,” a more explicit vow to stay on hold with rates for a prolonged time than it had offered in recent months.

Twelve of the 16 so-called primary dealers that trade securities directly with the Fed said in a Reuters poll they expected the central bank to hold overnight rates near zero into next year, if not further.

CREDIT EASING II

Having pushed overnight rates virtually to zero, the Fed has turned its focus to flooding stressed credit markets with cash in the hope of restarting lending and restoring growth -- a policy Fed chief Ben Bernanke has dubbed “credit easing.”

But even as financial markets cheered the Fed’s moved on Wednesday, some investors focused on the impact to the U.S. central bank’s balance sheet.

“Bottom line is the Fed is adding a trillion dollars to their balance sheet and that’s a lot of taxpayer money, ” said Greg Salvaggio, vice president for trading at Tempus Consulting in Washington.

Some investors said the action would be inflationary, and warned of the downside risks.

“It’s overtly inflationary and will inflate most assets, including crude and paper assets like stocks and bonds,” said Joseph Arsenio, managing director at Arsenio Capital Management in Larkspur, California.

Bernanke on Sunday said repairing the tattered financial system was necessary to secure a recovery for the U.S. economy, which has been stuck in recession for more than a year.

The Fed on Wednesday pointed to worsening prospects for the economy, dropping any specific reference to the likelihood of the recession ending this year. The central bank instead said only that the near-term outlook is “weak” and that stimulus measures should lead to a gradual resumption of growth.

This week, the Fed began taking bids under another marquee program designed to spur student, auto, credit card and small business lending. This program will initially aim to inject $200 billion into the economy, but the Fed has said it could be ramped up to $1 trillion.

While the Fed has gone to extraordinary lengths to try to get credit flowing, the economy is still in a nose dive.

U.S. gross domestic product shrank at a 6.2 percent annual rate in the fourth quarter, the deepest contraction since early 1982, and economists expect a decline of 5 percent or more this quarter. The unemployment rate, which has already hit a 25-year high of 8.1 percent, is expected to climb through the year.