Federal Reserve chairman Ben Bernanke has revived fears that the crisis in the sub-prime lending market could derail the US economy.
The outlook for the US looks worse, says Bernanke
Mr Bernanke cut growth forecasts for this year and 2008, blaming problems in the US housing market.
His comments dented recent stock market optimism, with the key US and European markets losing ground.
At the same time, US banks with exposure to the high-risk home loans market have started to suffer.
The head of the US central bank said the US economy "appears likely to expand at a moderate pace" over the second half of 2007, but downgraded full-year growth to between 2.25% and 2.5% in 2007.
Previous projections suggested US economic expansion would be between 2.5% and 3%.
The reason for the reduced growth expectations is the continued slump in the housing market, as monthly mortgage repayments rise and a number of lenders have made it more difficult for people with poor credit to access sub-prime mortgages.
As house prices soared and interest rates bottomed out earlier in the decade, this kind of lending - to people whose credit rating or income do not qualify them for regular mortgages - became big business for lenders.
But as rates have climbed once more, from a trough of 1% to their current 5.25%, both defaults on sub-prime mortgages and home repossessions are growing.
Mr Bernanke told Congress' House Financial Services Committee that the drag in housebuilding "will likely continue to weigh on economic growth over coming quarters", but added the magnitude of the growth should "diminish over time".
The New York-based Dow Jones index closed down 53.3 points, or 0.3%, at 13,918.2, a day after an extended rally saw it touch the 14,000 mark for the first time.
On the other side of the Atlantic, the UK's main FTSE 100 index dropped 92 points, or 1.38%, to close at 6,567.1 as investors worried about the affect a slower US economy would have on the earnings of many of the businesses listed. French and German shares also reacted badly.
Mr Bernanke's disappointing outlook came after US bank Bear Stearns said that two of its hedge funds were being wound up after losing billions of dollars invested in securities tied to high-risk sub-prime loans.
JP Morgan Chase also signalled further troubles in the lower end of the mortgage market, revealing it had tripled the amount of money set aside to cover loan losses to bolster its position in the face of growing defaults.
Even as the bank reported a 20% increase in earnings to $4.2bn, up from $3.5bn in its April to June period, it said it was reserving $1.53bn to write off bad debts.
Homeowners not considered high risk could also suffer from the current credit crunch, it said.