While inflation-adjusted consumer spending rose 0.2 percent in June, the Commerce Department also reported that consumer prices are up 2.4 percent year over year, the highest rate of inflation since April 1995.

A big increase in the Institute for Supply Management's manufacturing index deepened investors' interest rate worries, as a strong economy would make it easier for the Fed to raise rates without cutting off growth. The index rose to 54.7 in July, far better than the 53 reading economists had expected.

The Fed meets next Tuesday to gauge whether more interest rate hikes are needed to clamp down on inflation. The Commerce and ISM reports could push policy makers toward another quarter percentage point increase, which would put the benchmark rate at 5.5 percent. That would make capital more expensive for corporations — and hurt corporate earnings and share prices.

"The market is trying to read every tea leaf to gauge where the Fed is going to go, and we have a lot of data out this week," said Bryan Piskorowski, market analyst at Wachovia Securities. "You're going to see these kind of movements, up and down, before you get to the Fed meeting."

The Nasdaq composite index dropped 29.48, or 1.41 percent, to 2,061.99 as investors abandoned tech shares and small-cap issues, perceived to be risker in a rising rate environment.

Other stock indexes also fell. The Dow Jones industrial average fell 59.95, or 0.54 percent, to 11,125.73, and the Standard & Poor's 500 index lost 5.74, or 0.45 percent, to 1,270.92.

Bonds traded in a narrow range, with the yield on the benchmark 10-year Treasury note steady at 4.98 percent from late yesterday. The dollar rose against other major currencies, while gold prices rose.

Rising crude oil and natural gas futures added to Wall Street's worries, since the Fed has signaled that high energy prices could further feed inflation. Crude prices rose 51 cents to $74.91 per barrel due to multiple crises in the Middle East, while natural gas futures built on yesterday's 14 percent surge based on higher U.S. electrical demand in a nationwide heat wave.

Despite the inflation news, investors seem ready for the Fed to stop raising rates, concerned that more rate hikes would grind the economy to a halt, or even send it into a recession. So news of strength in the economy, like the ISM report, is seen as bad news.

"We have a market that wants to believe that the Fed is done and is therefore set up for disappointment whenever there is the smallest fragment of evidence of strength in the economy," said Stuart Schweitzer, global markets strategist at JP Morgan Asset and Wealth Management. "But the Fed can't rest unless there's clear unequivocal evidence of slowing economic growth."

The chronic concerns over inflation caused investors to again overlook corporate earnings, which have been strong overall. Verizon Communications Inc. fell 55 cents to $33.27 after reporting a 24 percent drop in second-quarter earnings that nonetheless beat Wall Street expectations by 2 cents per share. Investors were disappointed, however, with the company's full-year forecast.

Qwest Communications International Inc. posted a profit after a year-ago loss, helped by improved profit margins on flat revenues. Qwest gained 61 cents, or 7.8 percent, to $8.40.

The higher energy prices that has the stock market in flux helped Marathon Oil to double its second-quarter profits from a year ago. Marathon nonetheless slid 10 cents to $90.54 despite reporting earnings that beat analysts' forecasts by 59 cents per share.

Agricultural processor Archer Daniels Midland also benefited from the energy markets as demand for corn-based ethanol fuels helped the company double its quarterly earnings. ADM lost 10 cents to $43.90, however.

The automotive sector lost ground after the major U.S. auto makers reported double-digit sales declines. Ford Motor Co. fell 9 cents to $6.58, General Motors Corp. slid 93 cents to $31.30 and DaimlerChrysler AG dropped 61 cents to $51.04.

Declining issues outnumbered advancers by more than 3 to 2 on the New York Stock Exchange, where volume came to 1.67 billion shares, compared with 1.62 billion traded yesterday.

The Russell 2000 index of smaller companies fell 12.13, or 1.73 percent, to 688.43.

Overseas, Japan's Nikkei stock average fell 0.1 percent. In Europe, Britain's FTSE 100 closed down 0.8 percent, France's CAC-40 lost 1.22 percent for the session, and Germany's DAX index fell 1.5 percent.