The federal government's principal financing mechanism for building and modernizing public housing has come to "a screeching halt" because of questions over the tax exemption for short-term notes issued by the Housing and Urban Development Department.

HUD instructed field offices last week to stop signing new annual contribution contracts with public housing authorities. These contracts, known as ACCs, set the terms of federal subsidies for local public housing programs.

In addition, the department was unable to issue more than $1 billion in public housing notes that it sold on Aug. 1. The notes were to refinance maturing debt and to raise additional money for repairs and construction. Another issue, due out Oct. 2, has also been called off, and to meet obligations that will mature then, Secretary Samuel R. Pierce Jr. has asked President Reagan to increase HUD's authority to borrow from the Treasury.

HUD General Counsel John Knapp said that the moratorium on ACCs is "just a short-term thing" while the department waits for its borrowing authority to be increased. He said he expects no adverse impact on public housing authorities, since money from the note sales can be replaced by direct loans from the department.

But the reaction of housing officials ranged from apprehension to alarm.

Robert McKay of the Council of Large Public Housing Authorities said, "There is a lot of give in the system." But he added that problems will arise "if it goes on too long."

"The inability to sign new annual contribution contracts creates a very serious problem," said Robert Maffin, executive director of the the National Association of Housing and Redevelopment Officials. "It brings the process of modernization and construction of thousands of units to a screeching halt at a time when many communities are desperately trying to meet the housing needs of the poor."

The problem stems from Congress' attempt, when it passed the deficit reduction bill during the summer, to close a loophole on a financial maneuver known as arbitrage.

The tax exemption for housing notes was one of a small number of tax exemptions authorized by laws other than the tax code, and thus was not subject to the code's provisions restricting arbitrage. The provisions are designed to prevent issuers of tax-exempt bonds, which carry lower interest rates, from abusing their privilege by investing the proceeds in higher-yielding taxable bonds and making a big profit off the difference.

Issues by U.S. territories and possessions were also outside the tax code, and some authorities had been taking vigorous advantage of that.

But the wording of the new law seems to cover housing notes as well, of which more than $13 billion are outstanding. The Internal Revenue Service is now reviewing the question.

Knapp said be believes that if the IRS decides the housing notes are now covered by the tax code, HUD would not be found in violation of the arbitrage provisions and its notes would still be considered tax-exempt.

But even if HUD's current practices are found to be acceptable, HUD must find a way to convince the market that its future notes will be tax-exempt without having to subject each issue to review by a bond counsel. "I certainly hope it won't lead to that," Knapp said. "This is a system that involves a lot of small issues. I don't know if it can sustain that."

If the notes must comply, "my hope is that when we advertise these issues that we'll have some sort of certification . . . as to the use of the proceeds" that will be acceptable to investors so HUD will not have to get a bond counsel's opinion each time it issues the bonds, he said.