Shares in London and New York slumped ahead of today's Federal Reserve meeting. The Fed's Open Markets Committee is expected to signal tighter monetary policy in the light of the unexpected surge in inflation last month, the biggest since before the Gulf War.
Most analysts said the Fed was now more likely to abandon its neutral stance and adopt a "bias" in favour of higher interest rates.
The shift would be the Fed's way of tipping off the market that an increase is in the pipeline. Some economists would not rule out an immediate hike in the cost of borrowing.
Concerns that UK interest rates have reached their trough have been growing since Eddie George, Governor of the Bank of England, warned last week that they would have to rise at some point.
Mervyn King, Deputy Governor, reinforced this warning last night. He said that despite the strong pound and global crisis, inflation had been below its target in only one month so far since the MPC was set up.
"As the benign effects of those temporary external influences on inflation start to wear off, the challenges facing the MPC will become, if anything, even greater than in its first two years," he said.
The mounting interest rate uncertainty sent the Dow Jones Industrial Average, which fell almost 200 points on Friday, another 150 points lower yesterday morning.
In London, the FTSE 100, which fell more than 150 points, or 2.4 per cent, on Friday, lost another 134 points yesterday to close at 6,165.8 - a seven-week low.
The London blue chip index has fallen 7 per cent since peaking at 6,663 earlier this month.
On the foreign exchanges the pound climbed yesterday despite a report from the International Monetary Fund suggesting that the Government will have to take "specific actions" to bring sterling down to a sustainable Emu entry rate. The sterling index against other currencies gained 0.3 to close at 104.4.
The IMF said that the UK cannot both join Emu at a lower exchange rate and achieve convergence with the Euroland economies, since interest rate cuts to bring down the pound could over-stimulate UK growth.
David Owen, an economist at Dresdner Kleinwort Benson, said: "It is all very well for policymakers to try and talk the pound down, but the view in the investment community is that entry is just not going to happen at a much lower rate."
Equity analysts warned that the FTSE would fall further. Justin Urquhart Stewart of Barclays Stockbrokers said: "There's a reasonable chance that during the course of this year we will see the market go down by 10 per cent. But equally there's chance of it coming back up. It's like being in a coracle, bobbing up and down in a sea, surrounded by mines, any of which could go off."
Jeremy Batstone, head of research at NatWest Stockbrokers, said: "It is always dangerous to call the turn but over the next week we may see further evidence to show that a turning point has been reached."
Richard Batty, equity strategist at HSBC, said he would not be surprised if the Dow Jones fell back below 10,000. The FTSE 100 had already priced- in the growing inflation doubts by falling 400 points in three weeks, he said.
Other overseas markets took their cue from Wall Street following a 2.3 per cent drop in Tokyo and 2 per cent tumble in Hong Kong. In Europe, Germany's Xetra DAX shed 1.5 per cent.Reuse content