It's war. After months of skirmishing with recession, the Federal Reserve declared an all-out assault last Friday. It cut its key interest rate by half a percentage point. Commercial banks quickly followed suit by reducing their prime rate from 9.5 to 9 percent. We will now get a practical test of the power of monetary policy (the regulation of interest rates, money and credit flows) to combat the slump.

The skeptics are out in force. Ideally, lower interest rates will spur borrowing. More consumer buying, business investment and housing construction will revive the economy. Don't bet on it, say the skeptics. Gloomy consumers and businesses -- burdened with big debts and paralyzed by the Gulf war -- won't borrow. Weak banks won't lend. Easier credit won't matter. The Fed, as an old cliche' goes, will be "pushing on a string."

By all recent history, the skeptics should be proved wrong. "The 'pushing on the string' view calls to mind a vampire that keeps rising from the grave," scorns economist William Melton of IDS Financial Services. He says the argument is raised in every recession -- and always refuted by experience. The rub is that no two recessions are exactly alike. Something about this one could cause the Fed to blunder.

In some ways, its latest rate cut suggests that it has already underestimated the recession. The Fed acted immediately after the release of the January unemployment report, which showed a loss of 232,000 jobs. This was worse than most economists (including the Fed's) had expected. Since last June, employment has dropped 1 million. "The promptness of the cut {in interest rates} shows there's a new sense of urgency at the Fed," says economist Richard Berner of Salomon Brothers, the investment banking firm.

At best, lower interest rates won't work instantly. The Fed mainly influences the so-called fed funds rate: the rate at which banks lend overnight money to each other. The Fed affects this rate by buying or selling U.S. Treasury securities from banks. This increases or decreases the banks' available funds. When banks have more ready money, the fed funds rate falls. Last week, the Fed reduced it from 6.75 to 6.25 percent.

But changes in the fed funds rate don't automatically move other interest rates. Between the spring of 1989 and early last week, the fed funds rate declined from about 10 to 6.75 percent. Meanwhile, banks' prime rate dropped only from 11.5 to 9.5 percent. Conventional mortgages moved from 10.5 to 9.7 percent, and top-quality corporate bonds inched down from 9.8 to 9.0 percent. Each interest rate dances to a slightly different tune.

Consider bonds. There are more than $3 trillion in outstanding government and corporate bonds. These bonds are bought and sold daily by investors, who react to many factors: the inflation outlook; risk (will a bond be defaulted?); and the amount of new bonds being offered. If investors become more pessimistic, they pay less for bonds, and this raises interest rates. Suppose a $1,000 bond with an original interest rate of 8 percent can be sold for only $900. Its effective interest rate rises to about 8.9 percent (the bond pays about $80 in interest, which is an 8.88 percent return on a $900 investment).

What happened over the past 18 months is that greater fears about inflation and the soundness of corporate borrowers propped up bond rates. Bank rates have been affected by mounting losses and pressures from federal regulators to minimize bad loans. Consequently, banks kept up rates -- to improve profits -- and tightened lending standards. New funds have been heavily channeled into safe investments, such as U.S. Treasury securities. Some businesses complain they can't get credit.

Fed chairman Alan Greenspan says he's increasingly worried by this "credit crunch." It's "something that didn't bother many people a year ago," he said last week. Now, it's "having a very significant impact on economic activity." Lower interest rates are the Fed's attempt to overcome this inertia. In July, the fed funds rate was slightly more than 8 percent. Since then, it's been reduced seven times. Last week's cut was the biggest. With time, the ripple effects should be felt.

"The first thing that responds to lower rates is the stock market," says economist Cynthia Latta of Data Resources, a forecasting firm. And indeed, stock prices have risen since October. The quick cut in the prime rate indicates that banks "are ready to start lending again," she says. Lower mortgage rates and home prices are increasing housing affordability. A median-income family now has 17 percent more income than needed to buy the median-priced house ($92,000). That's better than any time since 1977, says the National Association of Realtors.

Finally, the Fed's own studies indicate that monetary policy remains potent. A change (up or down) of interest rates influences the economy as much now as in the 1970s and 1960s, according to a report in the Federal Reserve Bulletin. There's one big difference: shifting interest rates now have less impact on housing and more on exports. Lower interest rates tend to reduce the dollar's exchange rate, which then spurs exports.

But just because the Fed has power does not mean the power will be used wisely. There are dangers of doing either too much or too little. If the Fed lowers rates too rapidly, it could flood the economy with money and trigger higher inflation once a recovery occurs. By contrast, a weaker-than-expected economy would compound the risks of passivity. The economy is especially confusing now, because it's beset by unfamiliar forces: the Gulf war, which is delaying consumer and business spending; weak banks; and the collapse of the commercial real estate market.

For example, it's not clear the Fed can (or should try) to offset the depressing effect of the war. And there are complications from abroad. Just last week, for example, Germany raised its interest rates. This could slow Europe's economy and stymie American exports. Will that happen? No one really knows.

The war against recession and the Persian Gulf war present rough parallels. Each has its share of battlefield confusion. Yet, the outcome of each already seems clear. The war will be won, the recession will end. What's unclear is how fast, at what cost and with what consequences. These are the questions that matter. Our leaders will be judged on the answers.