(Recasts; updates prices, adds quotes, byline)
By Kevin Plumberg
NEW YORK, Dec 11 (Reuters) - The dollar fell sharply against the yen on Tuesday, but rose against the euro after the U.S. Federal Reserve took a step toward staving off an economic recession that was more modest than some expected.
In what many analysts described as the bare minimum, the Fed cut the fed funds rate by 25 basis points to 4.25 percent in order to blunt the impact of housing market weakness and tight lending conditions.
However, the Fed's decision to cut both its benchmark and discount rates by a quarter-percentage point injected a sense of uncertainty into financial markets, while opening a small window of opportunity for the dollar to rise higher as dealers cut their bets against the greenback.
"For now, this is a relatively good decision for the dollar, as risk reduction is forcing an unwind of short dollar positions and should boost the dollar over the next four weeks or so," said Ashraf Laidi, chief market analyst with CMC Markets in New York.
"The yen gains are a reflection of a resurgent reduction in risk appetite and a falling stock market," he added.
The euro slipped 0.3 percent on the day to $1.4670 <EUR=>. It was likely also weighed down by its 1.2 percent slide to 162.42 yen <EURJPY=>.
The Fed decision caused dealers to scoop up the low-yielding yen, anticipating an unwind in carry trades, in which investors borrow in currencies with low interest rates such as the yen to buy higher-yielding assets.
The dollar was down 0.6 percent <JPY=> at 110.92 yen as Wall Street stock indexes tumbled after the Fed decision confounded investors looking for even lower borrowing costs.
Sterling fell 0.5 percent to session lows of $2.0353 <GBP=>.
Just before the Fed announcement, interest rate futures markets had reflected a chance of as high as 40 percent that the central bank would cut the fed funds rate by a half percentage point, which presumably would have been negative for the dollar.
The Fed took many investors and analysts by surprise with only a quarter-percentage point reduction in the rate charged directly to commercial banks.
The U.S. central bank also replaced the usual assessment of the balance of risks facing the economy, with the statement: "Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation."
Kathy Lien, chief strategist with Forex Capital Markets in New York, said the statement reflected deteriorating fundamentals for the dollar, which should drag it lower in the coming days.
"The dollar could rally for the remainder of the week, but we expect weakness to resume as we get closer to 2008," she wrote in a note to clients.
With uncertainty gripping markets, the high-yielding Australian dollar dropped 1.3 percent to US$0.8730 <AUD=>. The New Zealand dollar <NZD=> fell 0.8 percent to US$0.7738.
Some analysts also said that by not slashing the fed funds rate more, the U.S. central bank would have to keep easing policy longer, a form of Chinese water torture for the dollar.
"By taking the gradualist approach, it now seems likely that this easing cycle will become a drawn-out affair, perhaps taking the funds rate to as low as a 2-handle," said Max Bublitz, chief strategist with SCM Advisors in San Francisco, referring to a fed funds rate below 3 percent. (Additional reporting by Steven C. Johnson; editing by Gary Crosse)