(FORTUNE Magazine) – DESPITE the seemingly endless dithering and prevarication, Washington has truly begun to attack the federal deficit. Progress will not be as impressive as President Reagan predicts -- his recent budget proposals entered fantasyland when they estimated how much money the Treasury would take in during the coming fiscal year, and he assumed Congress would cut domestic spending more deeply than seems likely. Yet his total spending estimates may turn out fairly close to the mark. The federal deficit should shrink appreciably this year and next. A lot of red ink will remain in 1988, but that is just as well. The withdrawal pace may be about all the economy can take if it is to keep growing. In concert with an improving trade deficit, the shrinking budget deficit will also diminish the chances of a disastrous plunge in the dollar as exchange traders recognize that the U.S. is finally getting its house in order. The federal budget can be figured many ways, and the deficit numbers vary with each measure. The most useful of these is the national income accounting method, which eliminates such essentially financial transactions as loans and counts business taxes as they are accrued, not just as they are paid. Figured this way, the Administration's deficit narrows from $211 billion last fiscal year (which ended September 30) to $186 billion in 1987 and $120 billion in 1988. Total federal spending could climb higher than the President's estimates for fiscal 1988 but probably not by much. Reason: Congress will likely boost its favorite domestic programs but will also cut the President's proposed military outlays. FORTUNE foresees a weaker economy than does the Administration; the shortfall in receipts will leave the 1988 deficit at $150 billion. That's still a healthy $60 billion below the record last year -- and it will continue to fall. To judge the amount of economic restraint or stimulus that the budget exerts, economists use the so-called cyclically adjusted budget, which smooths out the effects of the business cycle. In the version FORTUNE prefers, the economy is assumed to run along smoothly at 6% unemployment (see chart), compared with the 6.7% in January. Assuming a different unemployment rate would shift the level of the deficit but not the patterns of movement -- the most important part of the reckoning. By this measure the federal deficit rose from a $20-billion annual rate in - early 1981, when the Reagan Administration took office, to a $100-billion rate by the beginning of the recovery in late 1982. The deficit mounted to the $180-billion range by the middle of 1985 before leveling off. That near doubling of fiscal stimulus could well have overheated the economy dangerously had not the strong dollar siphoned sizable portions of domestic demand overseas, swelling the trade deficit. In the first half of this year, the cyclically adjusted deficit will average about the same as in calendar 1986 and then begin receding -- reaching a $105- billion rate by the middle of 1988. So after several quarters in neutral, the budget will shift abruptly toward restraint, with the deficit shrinking as much in a year as it had swelled in 2 1/2 years -- an amount equaling nearly 2% of GNP. This sort of jolt is the stuff of recession, but once again offsetting forces will come into play. The declining deficit (in the real world as well as the cyclically adjusted world) will make room for private credit demands to expand without pressing interest rates up. And business spending for capital goods and inventories, which has been weak for quite a while, may be ripe for expansion soon. Inventory-to-sales ratios are well below recession-causing levels. The ratio of inventories to final sales for all business is nearly 1.5% lower than a year ago, and inventory growth is only 0.5% a year. According to FORTUNE's quarterly survey of inventory policy, to be sure, business people would like their ratios 1% lower than they are now, and slightly more than half the executives would rather risk holding too little inventory than too much. Nevertheless, they expect to add inventory in the year ahead. Another reason to expect brisker stock building: U.S. production will benefit from faster-growing exports and slower imports. Not many people noticed, but in the fourth quarter the trade balance measured in physical volume, not in dollars, improved. The dollar has declined so long and so far that the stage has been set for a sustained improvement in trade after six years of deterioration. FORTUNE expects trade to become a major plus for the economy for at least the next couple of years. It will counteract the output- dampening effects of the new budget restraint, just as the downswing in trade softened the stimulus from the deficit's wild growth in the mid-1980s.

CHART: NOT AVAILABLE CREDIT: ILLUSTRATION BY BOB SCOTT CAPTION: The Deficit Goes on a Diet This calculated federal deficit smooths out the effects of the business cycle. Reagan's new plan to cut the budget stimulus should do better than last year's. DESCRIPTION: Line graph shows how the deficit would look with 6% unemployment.