By the end of 1999 the Federal Reserve was no longer worried about falling investment, rising unemployment, and recession. Instead, it was worried about a stock market boom causing overexuberance, and rises in capacity utilization and falls in unemployment to points at which rapidly accelerating inflation would become inescapable.
The high and growing baseline willingness of businesses to invest shifted the IS curve outward from its fall 1998 position. If the Federal Reserve wished to reduce the changes of an increase in inflation, higher interest rates were needed to moderate the effect of the outward shift in the IS curve on the level of real GDP relative to potential output.
In the second quarter of 2000, however, the high tech-heavy NASDAQ stock index crashed. By the fall of 2000 it became clear that investment had stopped rising. Real GDP growth had averaged 4.3% per year from 1997 to 1999, and was running at an annual rate of 4.0% in the first half of 2000. The second half of 2000, however, showed real GDP growth slow to an annual rate of 1.5%. The same factors that had induced the NASDAQ crash had reduced the baseline willingness of businesses to invest. Reduced baseline investment was shifting the IS curve inward, to the left. In order to avoid a recession and a substantial rise in unemployment, the Federal Reserve had to react to this inward shift in the IS curve by lowering real interest rates to stimulate investment and offset the decline in businesses' baseline willingness to invest.
By how much should the Federal Reserve have reduced interest rates? It was a difficult judgment call. Too little interest rate reduction would send the economy into recession, with falling production and rising unemployment. Too much interest rate reduction would run the risk of pushing production above potential output, and setting off the spiral of rising inflation that the Federal Reserve had feared since 1994.
In the end, the Federal Reserve reduced short-term nominal interest rates by 3.0 percentage points, from 6.5 to 3.5 percent, in a sequence of stages over nine months beginning in the late fall of 2000.
As of August, 2001, it appeared that the Federal Reserve policy had worked. There were signs that demand was about ot expand. Many economic observers were saying that the U.S. economic downturn might well be over. The consensus forecast was that U.S. real GDP in 2001 would grow by 1.6% (and see unemployment rise by 0.5-1.0%) and in 2002 would grow by 2.9% (with unemployment either stable or rising by a few tenths of one percent) before resuming faster growth in 2003. The weak spot in the world economy appeared to be not the U.S. but Japan--expected to remain in recession for most of 2001. Nearly four percent per year real GDP growth throughout 1999 and 2000 and 1.8% average real GDP growth in the first half of 2001 lent increased confidence to the belief that the boost in productivity growth in the second half of the 1990s was not a cyclical but a structural phenomenon: a "new economy" that could be expected to continue.
Then came the terror attack on the World Trade Center on September 11, 2001...