Group of Seven Split Over Inflation Strategy : Policy: Failure to fix the dollar’s value on exchange markets has created a political and economic hot potato among the seven major industrial democracies.

The United States and its major economic allies are engaged in a deadly serious game of economic hot potato--to see which will end up bearing the brunt of a new surge of inflation that is building in the major industrialized countries.

The struggle has become more intense in the wake of the recent failure by the seven major industrial democracies to fix the value of the dollar on the foreign exchange markets.

Some analysts say it is also at the heart of the latest flap between the Treasury Department and the Federal Reserve Board over how far to go in driving the dollar down. The Treasury wants the dollar to drop further to ease the trade deficit, but the Fed wants the greenback high to ward off inflation.

“This is a battle about inflation and the trade-off against the (large U.S.) trade deficit,” said Scott Pardee, a former Fed official now at Yamaichi International America, a securities house in New York.

The disagreements were temporarily put aside as all sides struggled to cope with last Friday’s stock market plunge, which forced the Fed to nudge U.S. interest rates down slightly and kept the outlook for the dollar uncertain.

But Washington officials and many private analysts say it is likely to re-emerge as the stock market turmoil abates and the foreign exchange markets return to normal.

“The dollar problem is only temporarily off the front burner,” said William C. Melton, chief economist for IDS Financial Services in Minneapolis. “The markets probably will be regaining their poise in about a week--and then we’ll be back to business as usual.”

The current wrangling among the United States, West Germany and Japan represents a decided departure from the practice of the past two decades, when--by mutual agreement--the United States absorbed most of the economic shocks that the Big Seven had to endure.

In the 1970s, for example, Washington willingly became the engine of worldwide growth and later accepted a steady fall in the value of the dollar even though a cheaper currency eroded America’s political power and exacerbated inflation here at home.

In the early 1980s, while the dollar was high, new economic stimulus from the United States kept European economies from plunging more deeply into recession. The U.S. willingness to shoulder the economic burden provided the cohesion that enabled the allies to work together.

Today, inflation is once again threatening to cloud the economic outlook. West Germany’s prices clearly are on the rise, and authorities there are wary that the spiral may be speeded by the influx of East Bloc immigrants who are certain to spur demand for consumer goods.

Japan is also experiencing higher than expected inflation pressures. And the United States, while apparently no longer in danger of an overheating economy, is struggling with an underlying 5% inflation rate that many analysts still find worrisome.

The economics of the hot potato struggle are simple: If the dollar’s value rises against the West German mark and the Japanese yen, then inflation pressures intensify in West Germany and Japan while easing in the United States. If it plunges, price pressures ease abroad but increase at home.

The reason is that having a high-valued currency, although making a country’s goods less competitive overseas, helps offset domestic inflation pressures by making imports less expensive and preventing domestic industries from raising their own prices.

By contrast, a low currency reduces a country’s trade deficit and helps domestic manufacturers, but it intensifies inflation at home.

Policy-makers in Washington, Bonn and Tokyo are aware that if the dollar were to plunge significantly, it would transfer the brunt of the inflation from West Germany and Japan to the United States. If the greenback’s value rose, the pressures would flow the other way.

The latest flap is the culmination of a long-brewing dispute between the Fed and the Bush Administration over how seriously the economy is threatened by inflation--and how much the Fed should change its policies to accommodate other economic goals.

The central bank is, by its nature, committed to putting the anti-inflation effort first. No other government entity has price stability as its major objective. It was Fed tightening, first in 1979 and later in 1987, that reined in inflation.

With the Administration and Congress still unwilling to reduce the budget deficit any further, and with inflation pressures still high, many analysts believe that the central bank has no choice but to hold firm. “The Fed is absolutely right,” Melton asserted.

But the Administration is pressing for a more buoyant domestic economy and wants the dollar lower to help ease trade pressures here. The trade deficit ballooned to $10.8 billion in August, up from $8.2 billion in July, and the White House fears that trend may persist.

“What’s different today is that, certainly as the Fed sees it, we don’t have a lot of room to move,” said Robert Z. Lawrence, a Brookings Institution economist.

Keeping with tradition, the Fed by and large has acceded to the Administration’s wishes on exchange rate policy. On Sept. 23, the Treasury persuaded the six other industrial democracies to launch a drive to cap the dollar’s rise. The Fed went along reluctantly.

Since then, however, the effort has fizzled. Despite repeated rounds of heavy intervention by the Big Seven countries, the greenback’s value has fallen only slightly in the foreign exchange markets. And it has risen again in recent days. The dollar Thursday stood at 142 yen and 1.85 West German marks--close to where it was before the Sept. 23 Group of Seven move.

More drastic steps--moves by the West German central bank and the Bank of Japan to raise their interest rates in hopes of easing demand for greenbacks--also have proved inadequate. The message from the markets was that the measures simply are not enough.

“It looks like they really would have to have some major changes in monetary policy now to have much effect,” said Brookings’ Lawrence. “What they’ve tried so far simply hasn’t done the job.”

The Group of Seven dollar-bashing effort is in disarray for several reasons.

For one thing, there is not the cohesion among Washington and its allies that there was, say, in 1985, when the Treasury launched a move to drive the dollar down. The Fed opposed that devaluation but did not have the political clout to block it.

And the mark and the yen are both being weakened by political instability in the West German and Japanese governments--also a new element. So the traditional jawboning and interest rate juggling is not having as much effect as some expected.