Lost Highway did an excellent job of leaving me confused right after watching it. After thinking about it though, I think that was part of David Lynch's plan in this film. There is no one hundred percent correct way to interpret this film; rather, Lynch wants the viewer to have to think and arrive at his or her own conclusion. In this sense it reminds me of Inception since there is no clear-cut interpretation to the ending, which causes everyone to discuss and watch it again. In this sense, Lynch was pretty successful.
That being said, I interpreted the first half of the movie to be Fred Miller's real life, with the second half being his alternate reality. As we saw in the jail scene, Fred was on the verge of losing his mind once incarcerated. Even before he was in jail, we could tell that he was unstable due to suspicions of his wife cheating on him and creepy videos he received in the mail. In his insanity, he either hallucinated or dreamed the part of the movie involving Peter Dayton. I think it was his way of trying to explain how his wife cheated on him. This would also explain the many connections between the lives of Fred and Pete. The main connection was between Renee and Alice, which is seen best in the sequences in which they describe a job that Andy offered them. The fact that they say the same exact thing leaves no doubt that they are the same person in Fred's mind. The image of him convulsing while driving at the end also indicates that he is being executed in the electric chair. This is the end of Fred's hallucination and also the end of the movie.