Ever since the Federal Reserve Board reversed course on Feb. 4 by raising the federal funds rate by a quarter of a percentage point for the first time in five years, the financial markets, and especially the mortgage market, have gone bonkers. To date the Fed's cumulative policy actions have elevated short-term rates by 1.25 percentage points and longer-term bond yields have risen by at least that much while also exhibiting volatile mood swings.

Further, equity values have bounced with bonds, falling in and out of favor depending on daily interest rate gyrations. On the recent news of the Fed pushing the federal funds rate up to 4.25% from 3.75%, bond prices soared and then several days later retreated. Are the markets finally comfortable with current Fed policy or will the markets continue to exhibit this frenzied behavior until the Fed completes all of its monetary policy objectives?

Questions of Timing

Most observers have characterized recent Fed behavior as a long range preemptive strike against inflation. Since inflation has not yet arrived in heavy doses, questions have surfaced regarding the usefulness and effectiveness of Fed policy.

Some think the Fed's tightening has been premature and some think that the Fed has not done enough. Liberal-minded economists like James Tobin believe the Fed's moves have been a mistake and blame the bond markets for being naive.

Conversely, most Wall Street economists are urging the Fed to do more, believing that the bond markets will not settle down until there is a perception that the Fed's job is done.

Pushing the criticisms aside, let's give the Fed a chance. If all goes well, the Fed will orchestrate a soft landing and extend the expansion by two to five years.

Mark Twain once said, "History never repeats itself, but sometimes it rhymes." The U.S. economy experienced two great expansions since World War II, 1961 to 1969 and 1983 to 1990. Both were extended because of soft landings. Using history as a guide, the Fed is only trying to replicate past accomplishments.

A closer inspection of the 1961-1969 and 1983-1990 great expansions contrasted against our current expansion may help shed some light on today's Fed policy objectives.

Factoring Out Inflation

For an apples-to-apples comparison, we will characterize Fed policy behavior by examining changes in real federal funds rates -- nominal interest rates minus inflation -- since interest rate levels differed substantially across the past three decades.

Of course, real federal funds rates are not the most reliable indicators of economic growth, but it is assumed that their impact on other rates influences economic activity.

Real federal funds rates fell 182 basis points from 1959 to 1961, generating the 1960s expansion. The economy exhibited robust growth, averaging about 5.4% annualized growth in real GDP during the 1961-to-1966 period. Toward the end of 1966, capacity utilization was approaching 86% and inflation was nearing the unimaginable 4% mark.

As if the Fed were pulling on the reins of a galloping horse, federal funds rates were rising to slow the torrid pace. By the fourth quarter of 1966, real federal funds rates had risen by 133 basis points, finally slowing economic activity. The soft landing had been accomplished.

Consequently, the economic expansion had been extended for another three years with the economy enjoying a more modest 3.2% growth during the 1967-to-1969 period.

Similarly, real federal funds rates fell by 203 basis points from the second quarter of 1981 to early 1983, generating the 1980s expansion.

However, with the gate open, the economy was immediately off to the races, averaging a robust 7.5% growth in real GDP during the first five quarters of the expansion. Even though capacity utilization levels were barely over 80% and inflation continued to hover in the 3% area, the Fed made the decision to slow the speeding train as a preemptive strike against future inflation.

The real federal funds rate rose by 204 basis points between the first quarter of 1983 and the third quarter of 1984, generating a more moderate 2.9% growth in real GDP for the remainder of the expansion, Again, overheating had been avoided, and a soft landing had been accomplished. The 1980s expansion had been extended by five years.

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