The stock and bond markets continued a frenzied rally yesterday, as the Federal Reserve Board appeared ready to pave the way for lower interest rates to prevent a worsening in the economy and a weakening of the financial system.

Late yesterday afternoon, after the stock market had closed sharply higher, the Federal Reserve announced that it had trimmed its key discount rate from 10 percent to 9 1/2 percent. Investors, anticipating that easing, pushed the Dow Jones Industrial Average up 20.88 points to 986.85, a 15-month high.

William Sullivan, vice president of the Bank of New York, said the discount-rate cut seemed to confirm reports that the central bank has determined once again to focus, at least partially, on achieving specific interest rate goals. It had abandoned this approach three years ago in favor of focusing on the rate of growth of the money supply.

In announcing the cut, the Fed said the "change is designed to maintain an appropriate alignment with short-term market rates." But Sullivan noted it was the first time in years that the Fed had used the discount rate -- the interest the central bank charges financial institutions to borrow from it -- to signal a change in policy rather than using it to confirm policy steps the Fed had taken in the open market.

Generally, when the central bank eases monetary policy, it does so by buying government securities on the open market, thereby injecting lendable funds into the banking system. The so-called federal funds rate -- the interest banks charge each other for overnight loans -- is highly sensitive to the central bank's actions.

Yesterday, however, the federal funds rate was about 9 5/8 percent when the Fed cut the discount rate to 9 1/2 percent. After the announcement, the federal funds rate fell to near 9 percent.

Shortly after the Fed's announcement, Mellon Bank of Pittsburgh trimmed its prime rate -- the key bank business lending charge -- to 12 3/4 percent. Most of the nation's major banks have a 13 percent prime, well below the 16 1/2 percent rate that prevailed at midsummer.

About 123.4 million shares of stock changed hands on the New York Stock Exchange yesterday -- the fifth-busiest day in the exchange's history -- as investors continued to believe the economy was too fragile for the central bank to hold hard to its money supply policies. On Thursday a record 147.07 million shares were traded as institutional investors such as pension funds continued to buy stocks steadily.

For the week, the Dow Jones average--probably the most-closely-watched indicator of the stock market's performance, climbed 79.11 points, its second-biggest weekly gain ever. The week's trading volume of nearly 490 million shares also was the second biggest ever seen on the New York Stock Exchange. Both figures were surpassed in the week ended Aug. 20 when the Dow average surged 81.24 points and volume was nearly 550 million shares.

James Balog, senior executive vice president of the brokerage firm Drexel Burnham Lambert Inc., said the market appears to be ignoring not only the dismal economy -- the government announced yesterday that the unemployment rate rose to 10.1 percent -- but the upcoming election, which could shift the balance of power "between the president and Congress. The market clearly seems to be saying 'not to worry,' " Balog said.

The flurry in stock buying still seems to be concentrated among institutions rather than individuals, according to Jerry Hinkle, chief trader for the brokerage firm Sanford C. Bernstein & Co. Since the stock and bond markets began a pronounced climb last August, trillions of dollars of paper wealth have been created, he said.

Although all but the West Coast stock markets had closed by the time the central bank cut the discount rate, the action sparked a sharp rally in the bond and money markets where trading is conducted through a loose electronic network rather than on the floor of an exchange.

At noon the central bank took steps to drain excess funds from the banking system, an action that suggested it was not backing off its policies. That stopped an early-morning rally in the bond and money markets and caused a temporary halt in the climb in stock prices.

But after the Fed announced the discount rate cut around 4:15 p.m., interest rates declined sharply and bond prices rose, Bank of New York's Sullivan said. The federal funds rate fell to about 9 1/4 percent by noon (from about 9.8 percent Thursday), edged back to 9 5/8 percent about 4 p.m., and then fell to about 9 percent at the end of the trading day.

Long-term bonds, whose prices rise when interest rates fall, rose about $5 for each $1,000 in face value during the last half hour of trading and about $10 on the day.

Investors also were heartened by the Fed's report that the money supply fell $2.7 billion last week and that banks had excess funds to lend for the first time in four weeks.

In the stock market, the New York exchange's own index closed at 75.0, up 1.23 points, and the American Stock Exchange market value index was up 4.67 points to 299.14