Greenspan told Congress that the nation’s banking system is well prepared to deal with rising rates, which the market interpreted as a new signal that the Fed will tighten its policy sooner rather than later. The Fed chairman didn’t directly discuss interest rate policy in his remarks to the Senate Banking Committee, but was expected to do so tomorrow, before the Joint Economic Committee.

Few analysts were surprised by Greenspan’s remarks, but his suggestion that banks could weather a rise in rates sparked a sell-off, sending the major indexes plummeting in the final hour of what had been a lackluster session. It also erased earlier gains on solid earnings reports from Dow components General Motors Corp., Pfizer Inc. and Altria Group Inc.

According to preliminary calculations, the Dow Jones industrial average was down 123.35, or 1.2 percent, at 10,314.50.

The broader gauges were also lower. The Nasdaq composite index closed down 41.80, or 2.1 percent, at 1,978.63. The Standard & Poor’s 500 index declined 17.73, or 1.6 percent, to 1,118.09.

"It’s a foregone conclusion that interest rates will move higher," said Kevin Caron, market strategist, Ryan, Beck & Co. "I wouldn’t be at all surprised if they do begin to raise rates, and you see a burst of economic activity as folks go out and buy that new car, or buy a home, before rates go up higher."

Worries that interest rates will rise sooner rather than later have distracted investors from profit reports this earnings season. While most economists don’t expect the Fed to raise rates at its next meeting on May 4, many believe rates will move higher by the end of the summer. With so much advance warning, however, the rate hike itself is not expected to have much negative impact.

Until rates do go up, the markets are likely to remain volatile as large investors react to each new piece of economic information. Long-term investors should take heart, however: The underlying message is that the recovery is solid and the economy is expanding.

"I think there’s more risk being out of the market than in the market right now," said Michael Murphy, head trader at Wachovia Securities in Baltimore. "The economy is showing us the expansion is for real and that will push investors back into the market. In the meantime, we’ll have days like this. The people who are really nervous more than likely are short term players."