America raises recession alarm as London escapes early freefall

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The US Federal Reserve promised to keep interest rates in the world's largest economy at rock-bottom levels well into 2013, in a signal that it is increasingly worried about a double-dip recession.

The central bank's declaration cheered investors who had been selling stocks relentlessly for the best part of a week, fearful that policy makers on both sides of the Atlantic have run out of ammunition to stimulate faltering economies. A big rally on Wall Street was the result, with the Dow Jones Industrial Average of US shares recovering 430 of the 635 points it lost in the previous session.

The Fed has held official US interest rates at zero since December 2008, but yesterday was the first time it has set a timeline for keeping monetary policy that easy, and it had immediate effects across the financial markets. Interest rates on some US government bonds, whose rise and fall is reflected in borrowing costs for millions of American homebuyers and businesses, crashed to never-before-seen lows.

"Downside risks to the economic outlook have increased," the Fed conceded last night, justifying its move, which came after a fractious meeting of its interest rate-setting committee. Three of the ten members dissented.

Traders expect the newfound optimism in the US to radiate to other world stock markets this morning, even if no one was making predictions on how long it might last. Days of selling pressure has pushed some markets down almost 20 per cent from their recent peaks – a decline that would qualify as a "bear market".

The FTSE 100 index of leading UK shares fell by as much as 5 per cent in early trading yesterday, dropping well below the 5,000 barrier, but bounced back into the black later in anticipation of the Fed's statement. It closed at 5,165, up 1.9 per cent.

In Britain, the latest figures on manufacturing confirmed other evidence of a pronounced slowdown in industrial production. The news will add to pressure on the Bank of England to follow the Fed and also ease monetary policy. Oil prices, closely linked to the strength of the world economy, slipped again, at one point falling below $100 a barrel – something that will take the edge off inflationary pressures. In China, more signs of overheating had heightened expectations that the Beijing will act to cool her economy.

In Europe shares also gyrated as jittery investors struggled again to minimise their loses with a second day of across-the-board sell offs. Germany's Dax hit an 18-month low, plunging over 7 per cent, and the French Cac index opened sharply lower, but both markets rallied later in the day.

Some analysts described investors' selling on Monday and yesterday morning as "hysterical" and said it had little to do with economic factors. "It is simply indicative of a loss of confidence in politicians, the banks and the ratings agencies," said Anita Paluch of ETX Capital in Frankfurt.

However there was better news on bond markets where the yield on both Spanish and Italian government bonds fell for a second day in response to the decision by the European Central Bank (ECB) to intervene on behalf of the weakened eurozone members and to begin buying up Spanish and Italian debt in order to reduce the two countries' borrowing costs. Both are struggling to avoid the kind of bailouts necessary to rescue ailing Greece, Portugal and Ireland.

Elena Salgado, the Spanish finance minister, insisted yesterday that her country did not need a bailout. She said Spain's total debt was 20 percentage points below the EU average.

Germany had been critical of the ECB's plan to prop up Spain and Italy, arguing that both countries should impose more stringent austerity measures before the bank intervened.

Alan Brown, chief investment officer at the fund-management group Schroders, blamed weak economic data across the eurozone, Britain and America over the past weeks, for the nervous markets. "Investors are recognising that the authorities have very few policy levers left," he said. "They have exhausted fiscal options and interest rates in most places are at rock bottom."

The Fed's move did little to stop the stampede into two safe-haven assets. Gold, seen as a refuge in times of political and economic certainty and a hedge against a falling dollar, hit a new all-time high of US$1,770/oz. The Swiss franc also traded sharply higher.

Meanwhile, economic data confirmed the complaints of ordinary people in China yesterday, when the National Bureau of Statistics (NBS) released price figures for July which showed that inflation surged to a three-year high, driven by a sharp rise in the price of food.

The data have fuelled fears that rising prices could cause political unrest, because the continuing popularity of the ruling Communist Party is based on strong economic growth, and higher prices can eat away at the benefits of a rising economy.

China's consumer price index showed inflation at 6.5 per cent last month, a 37-month high, the NBS said. China has wrestled with inflation in recent months, even as it has tried to squeeze the amount of money banks can lend, and by raising interest rates five times since October. The inflation rise comes as manufacturing and other economic indicators showed a slowdown last month, after repeated interest-rate hikes and other cooling measures designed to take some of the heat out of the economy.

The big fallers

Royal Bank of Scotland The taxpayer-backed bank was among the largest fallers on the FTSE 100 yesterday, with its share price closed down nearly 4 per cent, although it had rallied since earlier in the day when nearly a tenth of the value was knocked off. The Edinburgh-based lender has now lost about a quarter of its value in the past couple of weeks. At 26.2p a share, RBS is at about half the Government's break-even point of 51p.

Lloyds Banking Group Another bank that was bailed out by the Government saw its share price fall by 2 per cent last night. Banking shares have generally been hit hard, with investors worried about lenders' exposure to indebted European economies. However, Lloyds shares rallied later in the day after continued falls over the past six months.