New figures showed a sharp slowdown in US growth in the second quarter of this year, but wage costs jumped significantly. Alan Greenspan, the US Federal Reserve chairman, warned of his concern about the tight jobs market in America earlier this week.
In morning trading Wall Street plunged as much as 202 points, or 1.8 per cent. In London the FTSE 100 ended down nearly 180 points, or 2.8 per cent, with figures showing the economy gaining momentum adding to fears about the outlook for UK interest rates.
The dive in the bond markets was even more severe. The benchmark 30-year Treasury bond fell a full point, while the yield surged to 6.10 per cent from 6.01 per cent.
The dollar hit its lowest level against the yen for five months, falling below the important 115 yen mark and also below $1.07 to the euro.
Equity strategists warned of a sharp correction on Wall Street over the summer. Richard Batty of HSBC in London said: "We would expect a continued correction of up to 10 per cent." That would take the Dow Jones index below 10,000.
Michael Hughes of ING Barings Asset Management said: "There could be considerable market volatility for the remainder of the year."
The cost of employing a US worker rose at its fastest rate since the start of the decade, the Labor Department said.
The employment cost index (ECI) surged 1.1 per cent, up from a weak 0.4 per cent in the first quarter and its highest since June 1991. Analysts said the data made it almost inevitable that the Fed would raise rates in August.
The US economy grew by 2.3 per cent in the second quarter, its slowest for a year and below both last quarter's 4.3 per cent and forecasts of 3.3 per cent. The sharp slowdown undermined hopes of a "new paradigm" in the American economy.
Revisions to first-quarter UK GDP showed much faster growth than earlier estimates, and there were more signs of a housing-fuelled consumer spree.
This prompted fears about the outlook for UK interest rates. But experts said the Monetary Policy Committee, which meets next week, would face the dilemma of falling inflation in the next few months combined with a worsening outlook for inflation next year.
The National Institute for Economic and Social Research predicted that inflation would head towards 3.5 per cent - the top of the Bank of England's target range - by mid-2000 even though headline inflation could fall below 1 per cent this year.
Official statisticians revised up their estimate of growth in 1998 to 1.2 per cent from 0.7 per cent, and in the first quarter of this year from zero to 0.1 per cent, suggesting there is more momentum than had been thought to growth this year.
The detail showed a fall in the household saving ratio to 5 per cent, its lowest since mid-1989. According to separate figures yesterday, consumer credit jumped pounds 1.3bn in June. Mortgage lending rose by more than pounds 3bn, and the number of new housing loans approved was 102,000, up 5,000 from May. "There are worrying signs of imprudence creeping into the consumer side," said Leo Doyle of Dresdner Kleinwort Benson.
But, in an ominous signal for share prices, higher wage costs hit company profits, which fell by 5.6 per cent in the quarter despite lower dividend payments and taxes. The balance of payments plunged into the red by pounds 2.5bn in the first quarter, its worst since mid-1993.
Figures for second-quarter growth are due today.