Without much help from either Congress or the administration, the Federal Reserve Board has been fighting two enemies with just one gun. It has been using a tighter monetary policy that raises interest rates both to shoot down inflation and to defend the international value of the dollar.
So far, because the two enemies are allied - much of the problem the international dollar faces is the effect of inflation in the United States - that old carbine has been able to take on both enemies. Monetary policy makers and most administration economists concur that rising interest rates so far are not damaging economic growth and are needed to fight both rising prices and falling dollars.
But the Fed may soon face a dilemma: What does it do if it looks hike another increase in interest rates will kick the domestic economy in the teeth, while failure to raise them will set off another decline in the dollar's value on international currency markets? President Carter has pledged to fight both inflation and preserve the dollar.
"We haven't approached inflation and the dollar as segregated problems," according to one high Fed official. "If we come to that kind of dilemma, I don't know what we'll do."
The administration and the Federal reserve may find themselves having to gamble either that pushing interest rates higher will not bring on a recession or that halting increases in interest rates will not sabotage the efforts to prop the dollar.
A decline in August wholesale prices is heartening, but far from an omen that inflation is going to recede as a major public problem. However, if inflation tapers off for the rest of the year - until major labor settlements start to push up costs in 1979 - the Fed may be able to sidestep that dilemma, at least temporarily.
By then, Fed officials hope, monetary policy will have some assistance from other areas.
Clearly monetary policy needs some help, one top official concedes. Federal Reserve Board Chairman G. William Miller has been pleading for it privately and publicly for some months.
But so far, in the three-legged stool the administration is building to fight inflation and save the dollar, only the monetary policy leg has been glued in. By raising interest rates, the Fed is trying to make money more expensive here. That not only is supposed to discourage people from buying in turn, holding down pressures on prices but also is supposed to encourage Americans to borrow dollars abroad where they are cheaper (absorbing at least a few of the excess dollars from overseas).
The administration is working on the other two legs revising its domestic anti-inflation policy designed to elicit voluntary wage-price restraint from business and labor and developing various strategies to shore up the dollar's value.
But in the interim, monetary policy - the arcane exercises the Federal Reserve Board engages in to try to ration the amount of credit and money in the economy - will be the bulwark of the domestic anti-inflation fight as well as the international dollar policy.
If, however, the new anti-inflation policy is as ineffectual as the current one and unless the White House can come up with more than gimmicks (such as its recent announcement of a sharp increase in gold sales) to help the dollar, monetary policy is likely to continue to bear the brunt of the dollar-price fight.
That is why interest rates are being raised this time with the blessing of the White House (in sharp contrast to the criticism Federal Board chairman G. William Miller received early in the summer when the central bank raised rates.)
Many White House officials are worried about the chilling effect continued rising rates could have first on the housing market and then on the economy in general. But they also know well from the last recession that inflation itself can kill economic growth.
One top administration official with a populist abhorrence of high interest rates admits that, while interest rates are too high and in his view are feeding inflation rather than fighting it, until the government can get an effective anti-inflation program in place, the Fed has little choice but to do what it has been doing: raising interest rates. For even though the Fed's fight so far has proved fruitless, any sign of lack of resolve on the part of the central bank could rekindle speculation against the dollar.
Interest rates are already up a percent and a half since the spring. "And we have not seen the peaks," said Henry Kaufman, the respected chief economist of the investment banking firm, Salomon Brothers. They will continue to rise for the rest of the year, he said, and will be in the range of 9 to 10 percent.
The federal funds rate - the interest banks charge each other for overnight loans of excess reserves and the chief tool of domestic monetary policy - is about 8.25 percent compared with 6.75 percent in late April, and will rise further. Top grade, AAA corporate bonds "could test their 1974 peaks of about 10 1/3 percent," Kaufman said.
Only six weeks ago, Fed Chairman Miller said in an interview that he hoped interest rates had reached their peaks.Since then, his Federal Reserve Board has raised them a half percent more.
So far, admittedly, it appears that the Fed's fight to slow the growth of the money supply has been unsuccessful. Desite sharp increases in interest rates, demand for credit remains strong and the money supply - currency in circulation and checking accounts - continues to grow apace.
The central bank is still "chasing interest rates up, rather than driving them up," assets Robert Weintraub, staff director of the House subcommittee on domestic monetary policy. Or, as Kaufman puts it, "The bite of monetary policy on domestic inflation is not yet evident."
At some point, though, the Fed is going to push interest rates too high, warns Carnegie-Mellon University economist Allan H. Meltzer.
Weintraub agrees. "They (the Federal Reserve Board chase interest rates and sooner or later they catch them. And when they do, they keep right on going because they don't know until too late that they've caught them. That's when you get a recession.
"I'd tell them to forget about the dollar and adopt a long-run strategy aimed at slowly winding down the growth of the money supply over the next four years. That way recession risks are reduced substantially," said Weintraub, a monetarist economist who believes the growth of the money stock is the key economic variable.
Realistically, however, the White House has made a firm political pledge to support the dollar. To back off on any of the shoring-up moves would likely send vibrations through the supersensitive international currency markets and send the dollar falling again (its has stabilized in recent weeks).
The administration's most recent move to support the dollar came when it removed special reserve requirements from the dollars domestic banks borrow from their overseas branches, to encourage the banks to borrow abroad. At present, most of the borrowing runs the other way. Foreign branches have borrowings of more than $25 billion from their parent banks, while the branches have advanced the home offices less than $10 billion.
So for the new Fed action to have a significant impact, interest rates will have to be much higher here than abroad to induce domestic banks to hit up their overseas branches for funds rather than the domestic market. At present, the difference between the so-called Eurodollar rates and domestic interest rates are minimal.
"It's a dilemma. There's very little they can do," said Salomon Brothers Kaufman. "Something is going to have to come along to give monetary policy an assist." Kaufman cited wage-price restraints, restrictions on imports, or selective measures to stem dollar flows abroad. "None of them are very palatable," he said. "Nor is a monetary policy hearing the brunt of stabilization policy very palatable either."
So far, higher interest rates have not drained large quantities of funds from savings and loan associations as they did in 1974. Because S&Ls make most mortgage loans, home building dries up when they run out of funds to lend. Often, serious economic slowdowns follow.
Ad a result, as Miller has complained before, his Federal Reserve Board will be walking a monetary tightrope, trying to decide just how much monetary tightening is enough. The Fed often has failed to walk that tightrope properly in the past, although Miller - only six months on the job - has been carrying a balancing pole with reasonable success for most of his brief tenure.
But unless the administration comes up with successful anti-inflation and dollar policies to provide a net, the slightest gust of wind from either inflation or the dollar could topple the Fed and send the economy to an unprotected fall into an economic slowdown.