Borrowing from the experiences of the '60s and '80s, it is not difficult to comprehend the rationale for current Fed policy.

From the second quarter of 1989 to the fourth quarter of 1993, real federal funds rates have dropped by an astounding 432 basis points, dwarfing the 182- and 203-basis-point rate declines registered during the 1960s and 1980s expansions, respectively. Justifiably, the Fed is concerned that this sizable reduction in real rates could ignite economic activity, resulting in excessive inflationary pressures.

Utilization Rates

Although inflation remains relatively tame at present, capacity utilization rates are approaching 84% and the private economy (excluding sluggish government spending), led by durable goods spending, is approaching a 4% growth clip. All the more reason for the Fed to lean on historical precedent and raise the federal funds rate.

What if the Tobin camp is right and inflation is not just around the corner? The Fed's current tight policy would then be misguided but would cause only minimal damage.

Its objective is not to lift rates to levels causing a recession, but to slow economic activity down to about 2.5% to 2.75% (the economy's estimated noninflationary growth potential).

If the Fed is wrong, its policy will probably knock about a percentage point off real GDP growth, losing the economy between 500,000 and one million in potential job gains. But if the expansion continues, some of the lost job gains could be made up later.

However, if the Fed is right and it orchestrates a soft landing, the expansion could be extended out for another two to five years, generating millions of additional job gains.

How high does the Fed push rates to produce a soft landing? During the 1960s' soft landing, the Fed pushed up real federal funds rates by 133 basis points, while real rates rose by 204 basis points during the 1980s' experience.

Pushing the current federal funds rate up to about 4.5 to 5% from the 3% low registered earlier this year would generate a 125- to 175-basis-point rise in real rates (assuming a 2.75% to 3% inflation rate). This rise would be in line with the prior real rate increases of the previous two soft landings.

If successful and the expansion continues for another two to five years, the Clinton administration, facing a reelection campaign in 1996, would be in good shape.

Wait Till Next Year

Continued growth would spur job gains and interest rates would eventually reverse direction and begin to fall. After each soft landing in the 1960s and 1980s, real federal funds rates fell by 55 and 256 basis points, respectively. So there may be something to look forward to next year.

The Fed has the best of both worlds right now. Inflation has not yet reared its ugly head and the economy is growing at a healthy pace, providing a favorable backdrop for the mortgage business -- and for the Fed to engineer a slowdown.

The Fed and its Federal Open Market Committee must possess the resolve to see its current tightening initiatives through. The costs of not completing its mission are too great and, as we must acknowledge, history appears to be on its side.

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