The S&P BSE Sensex fell by 246 points on Monday as investors remained cautious ahead of the bi-monthly meeting of the Reserve Bank of India (RBI) on 29 September.
The Sensex closed at 25,616 points while the 50-share Nifty was down by 72 points, or 0.93%, to end at 7,795 points.
The RBI is scheduled to meet tomorrow and the markets widely expect the central bank to cut repo rate for the fourth time this year, by 25bps to 7%.
The US Federal Reserve's status quo decision on policy rate at this month's meeting has heightened expectations of a rate cut by the RBI.
"With the US Fed deciding to remain on hold, the Reserve Bank of India (RBI) now has a window of opportunity to ease its policy rate a final time in 2015 before likely opting for a pause," said Societe Generale in a note.
Besides, falling inflation and slowing growth have widened the scope for the RBI to ease policy rates further.
"We believe that the RBI will act because inflation is, structurally, on an easing path rather than because the government has increasingly been demanding a cut," said the note.
The sell-off in stock markets was also led by weak opening in European stock markets on the back of growing concerns over the slowdown in China. An official data showed that the industrial profits in China fell 8.8% in August, suggesting that the slowing growth has began impacting corporate earnings in the country.
Among the sectoral indices, consumer durables and reality were the top gainers while metal, IT, and auto were the major losers. Shares of Infosys and Wipro ended in the red following a sharp appreciation in the rupee.
Metal stocks like Vedanta, Tata Steel and Hindalco ended over 1% lower due to concerns over growth in the world's second largest economy China.
IDBI Bank shares rose by over 6% to Rs 78.70, posting an overall 36% gain in the past six trading sessions on the back of reports of stake dilution by the government to 49%.
Gold prices fell Rs 180 to touch a three-week low of Rs 26,810 per ten grams amid slowing demand for the metal and fears over interest rate hike by the US Fed. Last week, the US central bank indicated that it remains on track to begin monetary tightening this year. Silver prices also declined by Rs 315 at Rs 35,600 per kg.
