Mourinho suffered a disappointing debut season at United on the Premier League front, finishing sixth in the final standings and winning just eight of their 19 home matches.
However, it has been a different story so far this term with United yet to drop a point or concede a goal in front of their own fans and Phelan - who spent 14 years at the club in various coaching roles - believes the Red Devils are heading in the right direction under Mourinho.
"I think they are getting that (fear) back slowly because now at Old Trafford there is an atmosphere, there is an expectation and the players are reacting really well to it," Phelan told Sky Sports News.
"You have to build that reputation that fear and I think it was lost a little bit in the time Sir Alex [Ferguson] had left. In the off-season, he's gone about his business really, really well. I think he's come back fresh and he's added to the squad and I think they are looking at a squad now that can really go the distance."
"Right now he's building something, he's got off to a terrific start and he will want to continue that. But he certainly won't want to lose [Saturday's] game because I think it helps him build and it gives confidence to the players going forward."
United, who have dropped just two points from their first seven games, take on fierce rivals Liverpool at Anfield on Saturday.