"There are some players out there who were hoping or estimating they would cut a little bit more," said Stuart Freeman, chief equity analyst at A.G. Edwards & Sons Inc.
The Dow Jones Industrial Average fell 294.3 points, or 2.1%, to 13,432.8,, with just two of the blue-chip index's 30 components ending higher.
AT&T Inc. was up 4.1% after the telecommunications giant's earlier announcement that it would hike its dividend by 13% and buy back 400 million shares. .
Dow member McDonald's Corp. also closed ahead, its stock up 2%.
The Dow's decline marked its biggest one-day point and percentage plunge since Nov. 7, when it fell 360.92 points, or 2.6%.
On Tuesday, the index's largest laggards included financials, with American Express Co. recently off 3.3% and JP Morgan Chase Co. down 2.8%.
Citigroup Inc. fell 4.4% after an earlier rise on a report it would name Vikram Pandit as its chief executive.
The S&P 500 Index fell 38.31 points, or 2.5%, to 1,477.65, while the Nasdaq Composite Index declined 66.6, or 2.5%, to 2,652.35.
On the New York Stock Exchange, nearly 1.6 billion shares traded hands, and declining stocks outran advancers more than 5 to 1. On the Nasdaq, more than 2.2 billion shares were exchanged, and decliners topped advancers nearly 4 to 1.
Crude futures gained, closing $2.16 at $90.02. .
The Fed's decision to cut interest rates was expected, but the central bank moved more cautiously than equity investors had hoped. The Fed signaled its third rate cut since August might be enough.
The central bank lowered the federal funds rate by a quarter-point to 4.25%. The Fed also lowered its discount rate, the interest it charges on direct loans it makes to banks, by a quarter-point to 4.75%. .
"Obviously the market would have responded positively to a half (point cut in the Fed funds target rate) and a half (point cut in the discount rate, or even a quarter (in the Fed funds target rate) and a half in the discount rate," said Freeman.
"There is a little disappointment out there that this isn't going to add some of the oomph to the economy next year," he said.
Issues in action
Washington Mutual Inc. shares tumbled 12.4% after the lender said it would exit the subprime lending business and cut 3,150 jobs. It also plans to slash its dividend and sell $2.5 billion in convertible preferred stocks.
Shares of H&R Block Inc. fell 3.3% after the nation's largest tax preparer forecast a wider second-quarter loss as it winds down its troubled subprime-mortgage operations.
Kroger Co. shares slid 6.6% after the largest U.S. supermarket operator reported an 18% hike in third-quarter profit, topping Wall Street estimates, but offered a forecast that fell below consensus projections. .
Shares of Starbucks Corp. also fell, ending down 3.8%, after Goldman Sachs cut its rating to neutral from buy, citing slower same-store sales and declining new store productivity. .
Texas Instruments shares rose 0.3% after the company lifted its forecast, citing strength in demand for power notebook chips offsetting weakness in wireless.
European shares edged lower, paced by a decline in the property sector as investors fretted about tightening credit market conditions. .
Asian stocks rose, with markets in Hong Kong and Japan tilting higher as investors bought financials, also on anticipation of the Fed's rate cut. .
By Kate Gibson