Down for a third session straight, the major indexes extended their losses and interest-rate futures traders erased bets for a quarter-percentage point interest-rate hike as soon as September as Bernanke began testifying before Congress.
Fed fund futures still indicate a 28% probability of a rate hike to 2.25% by November, after recently pricing in a 50 basis point increase by then.
FOMC members' worry about inflation intensified in June, with most of the central bankers holding the view that inflation could climb more than expected in coming months, according to an economic outlook released by the Fed.
After falling more than 200 points, the Dow Jones Industrial Average recently stood at 1,0877.87, off 177.33 points, or 1.6%.
Of the blue-chip index's 30 components, all but three were posting losses early on, with the bleeding led by financials, including American International Group Inc. down 8.9%.
Shares of General Motors declined 2.9% after the auto giant said it would cut salaries, worker benefits and its dividend as it grapples with the severe downturn in the U.S. car market.
Johnson & Johnson led the minority gains on the Dow, rising 1.2%, after the world's largest health-care company reported moderately higher second-quarter earnings.
The S&P 500 declined 21.8 points to 1,206.5, with financials leading the losses hitting all 10 of the index's 10 industry groups, recently down 3.5%, followed by consumer discretionary, off 2.8%.
The technology-laden Nasdaq Composite fell 32.72 points to 2,180.15.
Volume on the New York Stock Exchange neared 417 million, and declining stocks outran those advancing 14 to 1. On the Nasdaq, 273 million shares traded, and decliners shot down advancers 4 to 1.
"The Fed stepped in and tried to bail out Fannie Mae and Freddie Mac, but talk continued to circulate that there would be nothing left. Add the FDIC takeover of IndyMac and the focus of the market shifted to who would be the next to fold," said Marc Pado, U.S. market strategist at Cantor Fitzgerald.
Illustrating the fears roiling the financial sector, shares of Wachovia Corp. fell 13.5% following the bank's downgrade to underperform by Oppenheimer.
Shares of already hammered Fannie Mae dropped 27.8%, while those of Freddie Mac declined 31.4%.
Ahead of Wall Street's open, stock index futures moved off previous session lows amid data on inflation and consumer spending.
The Labor Department reported wholesale core inflation, which excludes energy and food, increased by 0.2% in June, while overall whole prices climbed 1.8%. . Separately, the Commerce Department said retail sales climbed a disappointing 0.1% in June. .
The euro briefly hit a record against the U.S. dollar before falling back below $1.60. The euro high came even after data showing German investor sentiment dropping to a record low.
Oil futures fell $1.78 to $143.40 a barrel.
On Monday, U.S. stocks lost early gains as the financial sector took another beating.
By Kate Gibson