The dollar fell against the euro and high-yielding currencies on Friday after the Federal Reserve cut the discount rate and said downside risks to the U.S. economy have increased.

The central bank cut the rate governing direct Fed loans to banks by half-percentage point in a surprise move in an attempt to increase liquidity.

Investors and traders said the Fed's action on Friday could be seen as the last step before a reduction in the benchmark lending rate.

Not only the Fed cut the discount rate, in a sign banks are in serious need for cheaper financing, but it said the downside risks are increasing, said Gregory Salvaggio, a senior currency trader at Tempus Consulting in Washington. By no means is this positive to the dollar. Actually, this is the two-headed monster for the buck: lower interest rates and slower growth.

In midmorning trading in New York, the euro was 0.5 percent higher at $1.3491, its first gain against the greenback in a week, according to Reuters data. The dollar index, which tracks the performance of the greenback versus a basket of currencies, was down 0.6 percent.

In a statement announcing the decision, the central bank also said it was monitoring conditions and was prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets. The reduction took the primary discount rate to 5.75 percent from 6.25 percent. The federal funds rate remains at 5.25 percent.

The dollar was higher versus the Japanese yen, up 0.3 percent at 114.60 yen. Investors had bought the yen aggressively this week, and on Thursday the Japanese currency had its biggest one-day gain versus the dollar since 1998.

Risk aversion has rippled through other asset classes, with world stocks falling sharply. However, U.S. stock futures and European shares rebounded after the Fed's announcement.

Currency traders have used equity markets as a barometer of risk appetite for carry trades, in which market players borrow low-yielding yen to buy higher-yielding currencies.

We will have to wait and see how the stock market reacts, said Ron Simpson, director of currency research at Action Economics in Tampa, Florida.

(Additional reporting by Nick Olivari in New York)