Activity in the US service sector unexpectedly tumbled sharply last month for the first time in almost five years, a leading survey showed today.

The figures suggest that the Federal Reserve may have to continue to cut interest rates aggressively to stop the US falling into the worst recession since 2001.

The Dow Jones industrial average had fallen over 300 points to 12,325.37 by 7pm GMT while the FTSE 100 index in London closed down more than 2.5% to 5868.0.

The Institute for Supply Management reported its index of service sector business activity declined to 41.9 in January from 54.4 in December. Wall Street had forecast a slight slowdown but had still expected the sector to record some growth. However, the reading below the 50 mark, which separates expansion from contraction, was the first time activity in the service sector has shrunk since March 2003.

The headline index plunged from 53.2 in December to only 44.6 in January - the lowest since October 2001, just after 9/11.

"(The) non-manufacturing ISM suggests the wheels have fallen off the economy," said Julian Jessop, economist at Capital Economics.

New orders also contracted into recession territory, sliding back to 43.5 from 53.9 while the backlog of orders and inventories slipped lower - another sign of weakening activity in the sector.

The employment index also lurched down to 43.9 from 51.8.

Analysts said the services sector was taking a harder hit than manufacturing, which has been supported by overseas demand and helped by the dollar weakness compared with the more domestically reliant services sector.

However, there are signs that manufacturing is also struggling after the ISM index fell below 50 in December, before bouncing back to just above 50 in January.

Economists said the service survey suggested that current spending by US households has weakened substantially, hinting that retail sales figure next week will be very poor.

"It is also worth bearing in mind that in terms of employment and output, the non-manufacturing sector dwarfs the manufacturing sector, so is a more worrying development that more than offsets last week's good manufacturing news," said Rob Carnell at ING.

"The Federal Reserve might want to move rates in smaller steps at future meetings, but if the macro economy is deteriorating as fast and as far as this survey suggests, then markets may not allow them that luxury."