City sentiment knocked by gloomy economic forecasts

The FTSE 100 Index closed 131.20 points lower at 5245.21 – a 2.4 per cent fall – as the Dow Jones Industrial Average also tumbled soon after opening.

Investors grew concerned over the world's biggest economy after the Federal Reserve downgraded its outlook and began using proceeds from mortgage bonds in an effort to keep borrowing costs low.

The Fed said it would use cash from maturing mortgage bonds it holds to buy more government debt, maintaining the current level of monetary stimulus.

Some investors interpreted the measure as a signal that policy-makers want to support financial markets while the economy goes through a possible pause in growth, but some said that strategy seemed to have backfired.

Investors decided the US central bank's action was unlikely to have much immediate impact on the labour market and consumer spending, although the move reinforced expectations the Fed would keep interest rates low for longer.

Asian markets had earlier finished in the red after new figures showed China's industrial growth slowed further in July.

Bank of England Governor Mervyn King added to uncertainty by downgrading growth forecasts and warning the UK faced "a choppy recovery".

The pound weakened against the US dollar as analysts said the Bank's latest inflation report suggested interest rates were unlikely to rise any time soon. Sterling slumped nearly 1 per cent to 1.57 dollars.

Miners and banking stocks bore the brunt of the sell-off, with Lloyds Banking Group off 51/8p to 70p and Kazakhmys 73p lower at 1168p.

A shortened risers' board featured a number of defensive stocks as investors dived for cover amid the economic uncertainty. The risers included Smiths Group, which climbed for a second session amid speculation that the airport security scanners and medical devices firm could be in line for a break-up. Shares jumped 4 per cent, or 45p, to stand at 1193p.

The session saw more turbulence for holiday companies after Thomas Cook said profits will be at the lower end of market hopes.

Shares fell 33/4p to 1801/4p in the FTSE 250 Index while Thomson owner TUI Travel dropped another 131/8p to 190p after issuing a similar warning.

Elsewhere, Standard Life shares were lower despite a 10 per cent rise in half-year operating profits and 4.8 per cent increase in its half-year dividend. The figures were in line with expectations, but analysts said the pay-out to shareholders came in short of estimates, prompting shares to fall 73/4p to 2085/8p.

Prudential, which is due to round off a decent results season for the sector with a rise in its half-year dividend today, fell 201/2p to 562p.

Outside the top flight, building giant Balfour Beatty fell 33/4p to 2591/8p despite a rise in its order book to 14.6bn in the first half of 2010.

It suffered a fall in sales at its construction arm, but a clampdown on costs helped underlying pre-tax profits across the group jump 32 per cent to 141m during the period.

Meanwhile, building services company Rok plummeted 45 per cent – down 13p to stand at 16p – after it said it had uncovered "serious failings" in financial controls at its plumbing and heating division. The problems, which were revealed after an independent review, will have a material adverse impact on the firm's profits this year.

The biggest risers were Smiths Group, Randgold Resources up 25p to 5465p and Serco Group up 1/2p to stand at 5431/2p.