As you might expect, inflation accelerates. Inflation heads for 4 percent. Countering, the Fed tightens up on credit, forcing up the federal funds rate, a basic rate that immediately affects most other rates. By early 2004 it is up to 6.75 percent, compared to just 4 percent now. The stock market, already sliding because of the withdrawal of foreign funds and the slowing economy, falls farther.
Consumers turn pessimistic as jobs disappear and high interest rates put mortgages out of reach.
All this causes the housing market to collapse and business investment to decline. The high interest rates slow inflation, but as Latta and Wyss explain, they also bring export growth to a screeching halt. By the final months of 2003 the U.S. economy is in recession, and by mid-2004 the jobless rate is 7.7 percent, compared to 4.5 percent now. The Fed is forced to quickly reverse course, lowering interest rates. The economy recovers, and gross domestic product exceeds 5 percent, about double what it is now, but it must climb up out of the hole it has dug and that takes time.