As expected, the Fed's Open Market Committee raised the nation's short-term benchmark interest rate by a quarter percentage point to 2.75 percent. But in its policy statement, the Fed noted that "pressures on inflation have picked up in recent months," which analysts said was a sign that inflation could be a growing problem for the economy.

"The Fed conceded that there's a bit more inflation in the near term than people were expecting to hear about," said Jack Caffrey, equities strategist at J.P. Morgan Private Bank. "And if you get short-term inflation, there's the danger of it extending into the long term, and that means higher interest rates and lower multiples for equities."

The Fed, however, kept its "measured pace" language, which Wall Street has taken to mean steady quarter percentage point rate hikes in the future. A faster, more aggressive pace of rate hikes would make it difficult for companies to borrow the money needed to grow, and could stifle the overall economy.

The Dow Jones industrial average fell 94.88, or 0.9 percent, to 10,470.51, its lowest close since Jan. 28.

Broader stock indicators also fell sharply. The Standard & Poor's 500 index was down 12.07, or 1.02 percent, at 1,171.71, also its worst close since Jan. 28. The Nasdaq composite index lost 18.17, or 0.91 percent, to 1,989.34, falling to its lowest closing level since Nov. 2.

Oil prices fell substantially in what traders said was profit-taking ahead of tomorrow's inventory report from the U.S. Energy Department. A barrel of light crude for May delivery settled at $56.03, down $1.43, on the New York Mercantile Exchange.

Bonds also sold off sharply after the Fed's announcement, with the yield on the 10-year Treasury note rising to 4.62 percent, the highest yield since late July. The dollar was mixed but gaining against most major currencies, while gold prices slid to one-month lows.

"I think you have people looking at the market and not really knowing how to adjust their portfolios should inflation become a larger issue," said Sandy Lincoln, chief market strategist at Wayne Hummer Asset Management. "Maybe they're thinking the right way to transition is to consolidate into cash, so then they can stop, pause, look in all directions and see which way to go. So you see selling in both stocks and bonds today because of that."

Before the Fed decision, the Labor Department's Producer Price Index, a key inflation measure, gave Wall Street an early dose of enthusiasm. Wholesale prices climbed 0.4 percent, largely due to high energy prices. With volatile food and energy prices removed, "core" PPI rose just 0.1 percent, in line with economists expectations.

But given the choice between surprisingly higher interest rates or the Fed's measured pace, the reprieve from the PPI figure was temporary, as nearly any stance issued by the Fed would have raised the market's fears.

Among individual stocks, Alcoa Inc., a Dow component, said it will eliminate 2,000 jobs over the next year to streamline its operations, and expects to record one-time restructuring charges. The company also will sell its 46.5 percent stake in Norwegian metals and energy group Elkem ASA for about $870 million. Alcoa fell 50 cents to $30.96.

American International Group Inc. slumped $1.70 to $56.20 after the company fired its chief financial officer and another executive, saying the two were refusing to cooperate with government investigators. State and federal regulators are looking into the insurer's business practices.

General Motors Corp. again struggled with bad news about its finances. The Financial Times reported the automaker has backed out of an agreement that allowed earlier payments to its suppliers. GM lost 15 cents to $29.54.

Home builder Lennar Corp. announced a 39 percent jump in profits for the quarter, beating Wall Street's earnings forecasts by 16 cents per share. The company also raised its full-year earnings forecasts to $7.15 per share, up from $6.90 per share. Lennar gained 73 cents to $55.60.

Cereal and yogurt producer General Mills Inc. lost $2.10 to $49.42 after accounting changes and the sale of European holdings pushed the company to a quarterly loss. The company still managed to beat analysts' forecast by 4 cents per share.

Microsoft Corp., one of the most widely held stocks in the world, reached a 52-week low as the selloff took hold, closing 21 cents lower at $23.99. It was the lowest close for Microsoft since June 9, 2003.

Declining issues outnumbered advancers by nearly 5 to 2 on the New York Stock Exchange, where preliminary consolidated volume came to 2.13 billion shares, compared with 1.84 billion yesterday.

The Russell 2000 index of smaller companies was down 2.99, or 0.48 percent, at 618.58.