The Dow Jones Industrial Average fell by 265.7 points to 7599.32 in early trade in New York, the FTSE 100 Index closed down 174.7 , all the key European bourses fell and at one stage share trading was suspended in Brazil, where panicking investors have taken $9bn out of the country this month.
In a statement issued before the US market opened, the Bank of England's Monetary Policy Committee (MPC) took the unusual step of acknowledging that a further deterioration in the international economy could prompt a UK interest rate cut.
However, the MPC decided to keep rates on hold at 7.5 per cent for the time being, a move that angered industry bosses and union officials.
The MPC, which concluded its two day rate-setting meeting yesterday, said: "Although the Committee judges that the current level of interest rates is necessary to meet the inflation target, it recognises that deterioration in the international economy could increase the risks of inflation falling below the target. The Committee will continue to monitor these risks."
It was the first time in its 16-month history that the MPC has issued an explanatory statement with a "rates on hold" decision.
The Committee only usually issues explanatory statements when it changes rates.
Sterling fell sharply as the markets interpreted the MPC statement as a signal that rates had peaked.
The pound finished the day down more than 2 pfennigs at DM2.845. However, some economists cautioned against reading too much into the Bank's statement, saying that the markets had misjudged the MPC before.
Michael Saunders at Salomon Smith Barney commented: "The events of August 1997, when the MPC released a statement which was wrongly interpreted as signalling a rate peak, only for rates to rise again in November and February, should caution against reading things into MPC statements that are not actually said."
Yesterday's heavy market losses were not confined to London and New York. The Paris CAC 40 closed down 4.59 per cent at 3589.35 and the Frankfurt DAX down 4.32 per cent at 4744.05. In Brazil, trading was temporarily suspended after a 10 per cent plunge in the benchmark Bovespa index, prompting speculation that Brazil could be the flashpoint for another round of market chaos.
The Bank's decision to hold rates, despite the domestic slowdown and the international turmoil, drew fire from industry representatives and trade union officials.
Dr Ian Peters, deputy director general of the British Chambers of Commerce, said: "Today's decision will bitterly disappoint businesses that had hoped for a rate cut."
Alastair Eperon, chairman of the CBI's distributive trades panel, said the organisation's most recent survey suggested an easing of domestic demand. Growth in annual retail sales volumes in August was at a virtual standstill for the first time since September 1995, according to the CBI survey. However, the CBI noted that most retailers expected volumes to increase more quickly in the year to September.
Ken Jackson, the leader of the Amalgamated Engineering and Electrical Union, accused the MPC of "industrial vandalism".