US shares plunge 8% as recession fears take hold

US shares took their biggest tumble in 21 years, eclipsing even the giant sell-offs of the past few weeks, as fears grew that a recession is coming on more quickly and strongly than forecast.

A new set of grim retail sales figures contributed to the spreading gloom, and hedge funds and retail investors pulled money from the market as the selling accelerated in the final hours of trading last night.

Traders looking for signs that the credit markets may be unfreezing saw only mixed signals. Ben Bernanke, chairman of the Federal Reserve, warned activity would not rebound right away, even after the government's dramatic actions to stabilise the banking system.

The Dow Jones fell 733 points, or 7.9 per cent, to 8,578, and the wider S&P500 fell 9 per cent. Both performances were the worst since the period of the 1987 crash. Most of the selling came in the final hour, traders concluding it was due to forced selling by hedge funds – whose investors have been pulling cash out after big losses – and mutual funds, facing redemptions for scared retail investors.

Interest rates on inter-bank lending, calculated in London and known as Libor, fell sharply, suggesting banks are becoming more willing to lend to each other, but other credit market indicators suggested fear is still widespread. Strong demand for short-term US government debt sent the interest rates on these Treasuries close to zero, as nervous financial institutions chose to forego returns just so they can be sure their money is safe.

The previous evening, Janet Yellen became the first member of the Federal Reserve's interest rate-setting committee to declare the US is now in recession. Although Mr Bernanke stopped short of using that word, he warned "economic activity had been decelerating even before the recent intensification of the crisis".

Speaking to the Economic Club of New York, the Fed chairman said he was confident the government and regulators now had the tools needed to solve the crisis in financial markets, but he said we were just seeing the beginning of the effects on the real economy. "Stabilisation of the financial markets is a critical first step, but even if they stabilise as we hope they will, broader economic recovery will not happen right away," he said.

"Ultimately, the trajectory of economic activity beyond the next few quarters will depend greatly on the extent to which financial and credit markets return to more normal functioning."

The Commerce department's retail sales data for September showed US consumer spending was falling at a worse than expected annualised rate of 1.2 per cent – the worst monthly reading for three years. This means sales have been falling for three straight months, the longest period of decline since comparable records began in 1992. "This is hideous," said Ian Shepherdson, of High Frequency Economics. "The details show sales falling everywhere except gas stations and health stores, with the biggest declines in clothing, furniture, electronics and autos."

ShopperTrak RCT, a consultancy that measures shopper numbers as a way of predicting retail sales, said in the week ended 11 October they were down 2.7 per cent from the same period last year.

The publication of the Fed's "beige book", containing surveys of regional economic activity in the US, piled on the misery. The economy is weakening in all areas of the country, it said.