THE FEDERAL RESERVE IS IN A TIGHTENING mode following an aggressive easing pattern that pulled down short-term rates to historic lows. Past periods of monetary tightening meant big trouble for the housing industry, but this time figures to be different.

Starting Points A tightening process by the Fed ordinarily begins when the economy is overheating after a long economic expansion and upward pressures on inflation are serious, as was the case in the late 1970s and late 1980s as well as in 2000 when the Fed really dug in. Economic recessions came on the heels of each of those tightening periods.

This time, the economy still has a lot of slack in labor and capital markets. We're coming off a period of dangerously low inflation, and the Fed is moving from an extraordinarily stimulative monetary policy stance designed as defense against potentially destructive deflation in the U.S. economy. This emergency stance involved a federal funds rate of only 1 percent, which became negative when inflation began to edge up early this year.

Accelerators And Brakes Fed tightening in the late 1970s, late 1980s, and 2000 amounted to hitting the brakes, as did a rather bizarre episode in 1994 when the Fed felt the economic recovery was gaining too much momentum. The efficiency of those brakes was demonstrated in each case as housing shifted down and the overall economy weakened.

The Fed is now gradually lifting the accelerator off the floor rather than hitting the brakes. Passage of the deflation threat early this year removed the basis for the emergency monetary policy stance, and the Fed is moving back into a more normal zone. Policy is still stimulative, just not as stimulative as before.

Fed Objectives The Fed wants to shepherd the evolving economic expansion onto a self-sustaining trend characterized by a low and stable unemployment rate as well as low and stable inflation. This is no simple undertaking, but the Fed should be up to the task.

To accomplish this objective, the Fed will be striving to move monetary policy into a neutral position that neither stimulates nor impedes economic growth. With inflation around 2 percent, that implies a federal funds rate close to 4 percent, and success in this endeavor will keep a lid on long-term rates as well.

Whither Housing? Maintenance of low inflation is critical to the housing industry since long-term interest rates are highly sensitive to inflation. This means that builders should appreciate the Fed's march back toward a neutral monetary policy position even though the higher short-term rates impact the cost of credit for construction and land development.

If the Fed is successful, builders can look forward to strong and stable housing markets for a number of years. A recent NAHB analysis of long-term trends shows that demographics and other fundamentals should support production of nearly 1.5 million single-family homes per year.

David F. Seiders
Chief Economist, NAHB, Washington, D.C.