The Dow Jones industrial average closed down 95.57, or 0.85 percent, at 11,154.54.
The Fed raised the nation's benchmark interest rate Tuesday as expected, but the surprise for the markets came in an accompanying statement in which the Fed upgraded its view on the economy, suggesting that at least one and possibly even two more rate increases were in the cards.
That sent stock prices sharply lower, despite a strong reading on consumer confidence earlier Tuesday that had provided support to the market.
Broader stock indicators also fell. The Standard & Poor's 500 index fell 8.38, or 0.64 percent, to 1,293.23 and the Nasdaq composite index fell 11.12, or 0.48 percent, to 2,304.46.
Bond prices fell sharply in response to the Fed's announcement. The yield on the 10-year Treasury note, which rises when the price of the note falls, jumped to 4.78 percent from 4.71 percent late Monday.
The latest funds rate increase, the 15th consecutive rise of a quarter-point, leaves the rate at 4.75 percent, its highest level since April 2001.
The Fed said in a statement accompanying its decision that "some further policy firming may be needed," indicating that it was inclined to keep raising rates in an effort to contain inflationary pressures.
The Fed's two-day meeting was the first led by new chairman Ben Bernanke.
Craig Coats, co-head of fixed income trading at the brokerage Keefe, Bruyette & Woods, said investors had hoped to see signs that the Fed might have just one more rate increase to go in its current cycle. But with the Fed upgrading its assessment of the economy's strength Tuesday, Coats said one and possibly two additional more hikes were now likely.
"This was a little bit more than most people were looking for," Coats said. "The market is going to have to price this in over the next couple of weeks."
The Fed has been raising rates steadily since June 2004 under a program begun by Bernanke's predecessor, Alan Greenspan. Since that time, the benchmark federal funds rate, the interest that banks charge each other for overnight loans, has risen from a low of 1 percent.
Now that a federal funds rate of 5 percent is a given with at least one more rate increase likely, investors are now wondering how likely a further increase to 5.25 percent will be.
"I truly believe that they would like to stop at 5 percent, but if we get a really strong number (for economic growth) in the first quarter it may be hard to do that," said Wachovia Corp. senior economist Mark Vitner.
Oil futures rose following the threat of a strike in Norway. Light sweet crude for May delivery rose $1.91 to settle at $66.07 a barrel on the New York Mercantile Exchange
General Motors Corp. announced another round of layoffs Tuesday, and its shares fell 18 cents to $22.75. The move, affecting several hundred salaried workers, follows last week's announcement of buyout offers to more than 100,000 hourly workers.
Shares of eBay Inc. rose $1.72 or 4.6 percent to $38.87 after the online retailer received an upbeat report from a Goldman Sachs analyst. The shares had been down about 14 percent for the year prior to Tuesday's rally.
Level 3 Communications Inc. jumped 71 cents or 15.9 percent to $5.18 after the network operator raised its estimated quarterly operating income target to a range of $140 million to $150 million from a prior level of $105 million to $125 million.
Drug maker Eli Lilly & Co. fell $2.29 or 3.9 percent to $56.38 as two analysts downgraded the company. One said Lilly was under pressure from sluggish growth at some of its major products; a poor late-stage pipeline for new drugs and competition in drugs for diabetes and depression.
The Russell 2000 index of smaller companies fell 2.76, or 0.37 percent, to 751.27.
Declining issues outnumbered advancing ones 2 to 1 on the New York Stock Exchange. Trading volume was 1.56 billion shares, up from 1.38 million at the same time Monday.
Overseas, Japan's Nikkei stock average rose 0.2 percent. Britain's FTSE 100 fell 0.6 percent, Germany's DAX index was down 0.4 percent, and France's CAC-40 was down 0.2 percent.