The nation's money supply edged down for the second week in a row, the Federal Reserve reported yesterday, but interest rates rose on the news as financial markets had hoped for a larger decline, analysts said.

The narrow, M1 measure of the money supply dropped by $200 million in the week ending August 17, the Federal Reserve reported. However, it revised upward by $200 million the money supply average for the previous week. M1, which includes cash and checking accounts, averaged $516.9 billion in the latest week the Federal Reserve said. This left it still outside the 5 percent to 9 percent target range that the Fed has set for M1 growth in the second half of this year. The broader measures of money supply are within the Fed target ranges.

Separately, the Fed yesterday released minutes of a mid-July meeting of its policy-making committee that showed the central bank decided then on a further slight tightening of credit conditions. Several committee members had thought that such a tightening need not lead to much more of an increase in interest rates than had already occurred.

The Fed's latest meeting of its policy-making Open Market Committee occurred earlier this week, but the minutes from that will not be published for several weeks. Financial markets were jittery all last week, as traders tried to decipher what the Fed decided at its latest meeting. Most believed that the central bank had not decided on a further tightening this week. However, dealers and economists were divided on whether the central bank had opted for a slight easing of monetary conditions or for holding the same degree of restraint as before.

Yesterday's money supply figures persuaded many in the markets that the Fed would not ease up just yet."The general feeling is the Federal Reserve will hold to a stable stance, which means interest rates should be relatively unchanged in the weeks ahead," said David M. Jones, economist at Aubrey G. Lanston & Co.

The key federal funds rate, on reserves lent by financial institutions to one another, has declined in recent days, although Fed action on Thursday pushed it up to 9 1/4 percent and it was up further at 9 3/8 percent yesterday. It has been higher earlier this month.

Fed Chairman Paul Volcker told Congress last month that the combination of rapid monetary growth and a stronger than expected economic recovery had led the FOMC to tighten credit mildly in May. However, he did not indicate whether that tightening was intensified last month. Yesterday's Federal Reserve Board minutes show that a majority of members "indicated that they could support a slight further increase in the degree of reserve restraint." Fed Governor Nancy Teeters opposed the move and was in favor of maintaining the existing degree of restraint, while Fed Governor Henry Wallich favored a more substantial tightening.

The Fed minutes commented on the strength of the dollar and noted that this has contributed to a widening balance of payments deficit. In the policy directive issued at the end of the July 12-13 meeting the FOMC said that it aimed at helping further reduction in inflation, sustainable recovery and to "contribute to a sustainable pattern of internatonal transactions."

The Fed minutes show that the committee continued to put greater emphasis on the broader measures of the money supply, and said that the weight to be put on M1 would depend on whether it seemed to be moving more in line with the patterns of the past. The committee said that it expected the further slight tightening to "be associated with growth of M2 and M3 at annual rates of about 8 1/2 percent and 8 percent respectively from June to September. The growth of these aggregates in July was well below that.

However, the FOMC had expected that M1 growth would slow to about 7 percent at an annual rate during the third quarter, and it is still well above that.