The Federal Reserve Board has now become the leading force in this country's economic policy. That's why you are seeing a steady increase in commentary and speculation on what it's up to. This prominence is rather new for the Federal Reserve, thrust on it by the enormous Reagan budget deficits. They have to be financed through the banking system, and it makes a great difference how the Federal Reserve, as the country's central bank, manages that process.

Traditionally, the Federal Reserve engineered its monetary policy to keep interest rates stable. But as inflation began to rise, that got complicated. What it wanted to stabilize was the real interest rate -- which means the nominal rate minus the inflation rate. But the future inflation rate is always a guess, and in the 1970s governments always guessed too low. The result was that during the decade the Fed generally held nominal interest rates too low -- sometimes lower than the inflation rate itself. Not surprisingly, borrowing soared -- followed by inflation.

When Paul Volcker was appointed chairman of the Federal Reserve in 1979, he brought with him a conviction that trying to outguess inflation was both impossible and dangerous. Instead, he proposed that the central bank change its basic policy and set the growth of the money supply as its target. That was the famous switch of October 1979.

For all of its pitfalls, targeting the money supply seemed a far better way to control inflation than targeting interest rates -- and that's a judgment with which the historians of the next century will probably agree.

In its first year of the new policy, the Fed made an unwelcome discovery. According to the textbooks, interest rates rise when the credit demands of a growing economy press the limits of the money supply. But the Fed found in 1980 that interest can also rise -- with the speed of a rocket -- when lenders think that the money supply is out of control and more inflation is coming. There were two of those lenders' panics in 1980, and the year ended with interest at hair-raising levels.

The Fed's position shifted at the beginning of last July. It was getting a rising chorus of reports and warnings that the high interest rates were beginning to do serious damage to the basic structure of American industry. The recession was not only weeding out weak enterprises but eroding the strength of some of the leaders. The chances of a wider business collapse were increasing. The money supply actually began to fall.

The Fed then started pushing more money into the banking system, and in early July the short-term rates began to come down. Then the Fed began dropping the discount rate, the interest rate at which it lends to banks, signaling its further intentions. But it brought the discount rate down with gingerly caution, half a percentage point at a time, in fear of igniting another lenders' panic.

By the end of August, the money supply was rising rather sharply, and the Fed paused, through the month of September, presumably to see what the market reaction would be. Short-term rates had edged up a little, uneasily, in late August, with the Mexican crisis. But they moved back down in September, indicating to the Fed that it had the latitude for further easing.

By this time, the money supply was already somewhat higher than the Fed's stated limit. That's why the Fed deliberately leaked word to the public at the beginning of October that for the present it would not enforce the limit. And that's the point at which there was suddenly a lot of talk about the Fed's having abandoned monetarism, etc.

Rates, fortunately, have held steady. But the money supply -- measured by the fallible but highly visible M1 -- shot up extremely fast in the first half of October, creating ripples of concern in the money markets. The Fed now appears to have paused again, to be sure that it does not risk igniting another leading force in this country's economic policy. That's why you are seeing a steady increase in commentary and speculation on what it's up to. This prominence is rather new for the Federal Reserve, thrust on it by the enormous Reagan budget deficits. They have to be financed through the banking system, and it makes a great difference how the Federal Reserve, as the country's central bank, manages that process.

Traditionally, the Federal Reserve engineered its monetary policy to keep interest rates stable. But as inflation began to rise, that got complicated. What it wanted to stabilize was the real interest rate--which means the nominal rate minus the inflation rate. But the future inflation rate is always a guess, and in the 1970s governments always guessed too low. The result was that during the decade the Fed generally held nominal interest rates too low--sometimes lower than the inflation rate itself. Not surprisingly, borrowing soared-- followed by inflation.

When Paul Volcker was appointed chairman of the Federal Reserve in 1979, he brought with him a conviction that trying to outguess inflation was both impossible and dangerous. Instead, he proposed that the central bank change its basic policy and set the growth of the money supply as its target. That was the famous switch of October 1979.

For all of its pitfalls, targeting the money supply seemed a far better way to control inflation than targeting interest rates--and that's a judgment with which the historians of the next century will probably agree.

In its first year of the new policy, the Fed made an unwelcome discovery. According to the textbooks, interest rates rise when the credit demands of a growing economy press the limits of the money supply. But the Fed found in 1980 that interest can also rise--with the speed of a rocket--when lenders think that the money supply is out of control and more inflation is coming. There were two of those lenders' panics in 1980, and the year ended with interest at hair- raising levels.

The Fed's position shifted at the beginning of last July. It was getting a rising chorus of reports and warnings that the high interest rates were beginning to do serious damage to the basic structure of American industry. The recession was not only weeding out weak enterprises but eroding the strength of some of the leaders. The chances of a wider business collapse were increasing. The money supply actually began to fall.

The Fed then started pushing more money into the banking system, and in early July the short-term rates began to come down. Then the Fed began dropping the discount rate, the interest rate at which it lends to banks, signaling its further intentions. But it brought the discount rate down with gingerly caution, half a percentage point at a time, in fear of igniting another lenders' panic.

By the end of August, the money supply was rising rather sharply, and the Fed paused, through the month of September, presumably to see what the market reaction would be. Short-term rates had edged up a little, uneasily, in late August, with the Mexican crisis. But they moved back down in September, indicating to the Fed that it had the latitude for further easing.

By this time, the money supply was already somewhat higher than the Fed's stated limit. That's why the Fed deliberately leaked word to the public at the beginning of October that for the present it would not enforce the limit. And that's the point at which there was suddenly a lot of talk about the Fed's having abandoned monetarism, etc.

Rates, fortunately, have held steady. But the money supply--measured by the fallible but highly visible M1--shot up extremely fast in the first half of October, creating ripples of concern in the money markets. The Fed now appears to have paused again, to be sure that it does not risk igniting another surge of panic.

The Fed's dilemma remains the same. If it supplies too little money to the banking system, it creates a credit shortage and rates will rise. If it supplies too much money too fast, it feeds fears of inflation and rates will rise.

What does that mean for the future? My own guess is that the Fed will continue the pattern of the months since early July. It is now steering policy not by the monetary statistics but by the indicators of the real economy of production, jobs, sales and profits. There is likely to be a succession of small moves, nudging rates downward, with long pauses for reaction, in the urgent hope of reaching the point at which an economic recovery begins.

Perhaps it occurs to you that the Federal Reserve Board is attempting a very difficult policy with very limited means. That's true. It won't get any easier until either Congress or the electorate forces the administration to get its deficits down.

The writer is a membe Engineering a Recovery?

The Federal Reserve Board has now become the surge of panic.

The Fed's dilemma remains the same. If it supplies too little money to the banking system, it creates a credit shortage and rates will rise. If it supplies too much money too fast, it feeds fears of inflation and rates will rise.

What does that mean for the future? My own guess is that the Fed will continue the pattern of the months since early July. It is now steering policy not by the monetary statistics but by the indicators of the real economy of production, jobs, sales and profits. There is likely to be a succession of small moves, nudging rates downward, with long pauses for reaction, in the urgent hope of reaching the point at which an economic recovery begins.

Perhaps it occurs to you that the Federal Reserve Board is attempting a very difficult policy with very limited means. That's true. It won't get any easier until either Congress or the electorate forces the administration to get its deficits down.