Although the Federal Reserve Board pushed interest rates higher last week to bolster the dollar, this has not significantly altered the outlook for interest rates in the current economic cycle.
Those who thought that interest rates would soon peak still think so. Those who feel that interest rates still have much higher to go before credit demands are sufficently restrained to also moderate inflation continue to hold that view.
What is undisputed is that the combined effort of the Fed and the Carter administration to defend the dollar has so far spurred not only the U.S. currency but also the stock and bond markets.
Yesterday stocks closed up 4.59 points to finish the day at 897. Bonds meanwhile rallied sharply on the continued strength of the dollar and on the news that durable goods order fell a sharp 5.5 percent in July, the biggest drop since December, 1974, when the economy was rapidly plunging into recession.
Normally a drop in this key economic indicator would be greeted as a negative development, because it presages weakness in the U.S. economy as a whole.
But weakness - and a hopefully mild recession - is what the markets seem to be looking for just now.
That is because inflation - which climbed at a 10.7 double-digit rate in the second quarter - is the prime cause of concern to the financial markets currently, and the key factor as well behind the dollar's recent weakness.
And any sign that some of the steam is going out of the inflationary build-up - even if it means a recession - is being greeted positively. A declining tempo of economic activity, it is felt, would reduce the necessity for the Fed to further raise interest rates, either to defend the dollar or to fight domestic inflation.
So the markets seem willing to put up with higher interest rates for the short-term, in order to avoid much higher interest rates over the long haul.
Last week the Fed moved its discount rate, or what it charges member banks to borrow up 1/2 point to 7.75 percent. And it further tightened the credit reigns by increasing the federal funds rate 1/4 point to 8 1/8 percent.
Despite the latest hike, David Jones, an economist with Aubrey G. Lanston & Co., a major dealer in government securities, believes "we may be at the end of the series of fed firming moves that began in April."
Jones believes that, at most, the Fed will tighten credit in the form of the Fed funds rate "one small notch more to 8 1/4 percent." He reasons that "in terms of economic outlook, we're on a high but flat plateau in terms of consumer and housing activities."
Consumers have provided the big spur to the more than three years of economic advance. But Jones notes that the drop in durable goods orders, which represent such big ticket items as autos and appliances, and a widespread expectation that housing will finally weaken during the fall, are setting the stage for a less restrictive credit scenario.
Without any significant thrust from either of these sectors in late 1978, any chances of a real credit crunch, or severe tightening by the Fed are quite remote. All in all, the Fed actions have been taken in stride by the bond markets, and the outlook is quite constructive.
Another factor helping to ease concerns about a credit crunch is a sudden and major downward revision in estimates of how much the Treasury will have to borrow in the fourth quarter of this year to finance the U.S. budget deficit.
Earlier guesses had put the Treasury financing needs for the fourth quarter at $25 billion - or a scary $100 billion annual rate. But because of recent increased purchases of Treasury securities by foreign central banks, who accumulated dollars in defending their own currencies, and larger than expected demand from state and local government that estimate has now been revised down to $20 billion. Also contributing to the revision are higher than expected tax receipts and lower than projected federal expenditures.
Meanwhile, however, there is the contrary point of view that says credit demands will continue to skyrocket during the latter part of 1978 and into the first months of 1979, forcing interest rates much higher despite Fed reluctance to initiate a credit crunch.
Moody's investor services, in its latest survey of the bond markets, warns investors that "short-term credit expansion is indeed reaching boom proportions."
"In a nutshell," says Moody's, "the investor today is faced with considerable uncertainty in making investment decisions in view of strong inflationary pressures in the system coupled with ever larger amount of credit needed simply to keep the economy from slipping - somewhat like trying to inflate a balloon with a hole in it."
It goes on to say that "a basic reversal of the current essentially bearish tone in the credit markets must await a more fundamental realignment of the basic forces shaping present market attitudes."
But some analysts think they see the outlines of such a fundamental realignment now. The inflation rate, they believe, will ease in coming months, along with the economy and the U.S. trade deficit will also continue to show improvement.And that, they say, bodes well for the dollar interest rates and the financial markets.