Interest rates continued to fall yesterday, in response to an infusion of cash into the nation's banking system by the Federal Reserve over the past week and an easing of market fears about higher inflation and a falling dollar.

The biggest drop came in yields on three-month Treasury bills, which fell a quarter of a percentage point yesterday to 5.61 percent. A week ago, they stood at 7.17 percent. As the demand for these securities increases and prices rise, yields decline because buyers are receiving the same return for a larger investment. Part of the increased demand was attributed to a so-called "flight to quality," as investors pulling funds out of the stock market poured them into safer Treasury securities.

Long-term government bond prices, which did an about-face on Monday after falling rapidly over the past two months, continued to rally. Yields on 30-year Treasury bonds, which were 10.22 percent last Thursday, dropped to 9.45 percent yesterday.

The decline in long-term bond rates, however, has not extended to so-called junk bonds -- securities issued by companies with low credit ratings. Yields on such bonds, which have helped finance many corporate takeovers and buyouts, had not gone up nearly as much as they had on government and high-grade corporate bonds. But in the last few days, prices of junk bonds have fallen sharply while those of the higher-rated securities rose.

The decline in the higher-rated long-term bond yields likely will reverse part of the recent run-up in home mortgage rates, which closely follow changes in bond yields, analysts said.

Meanwhile, the closely watched federal funds rate -- the rate financial institutions charge when they lend cash to one another -- was down to 6.5 percent from 7.76 percent last Thursday, the day the Federal Reserve began to pump more money into the banking system to calm the markets and head off a surge in short-term rates, analysts said.

On Friday, when stock prices began their plunge, the Fed again provided cash to the system, knocking the federal funds rate down to 7.55 percent.

But the big decline in the funds rate came Tuesday and yesterday after Federal Reserve Chairman Alan Greenspan issued a brief statement saying the Fed stood ready to provide the banking system with enough cash to keep the economy operating smoothly and market participants decided that the stock market debacle left the central bank with no choice but to do exactly that. The Fed intervened by purchasing government securities from bond dealers for cash, which the dealers then deposited in the banking system.

Prior to this switch last week, the Fed had been going the other way, reducing the availability of cash to the banking system to boost interest rates and combat market fears of inflation and a falling dollar.

This sort of action by the central bank has been contrasted by some analysts with the way in which the stock market crash of 1929 was allowed eventually to lead into the Great Depression. In that case, the Fed pursued a radically different policy that caused a decline in the money supply, which many economists say was a major contributor to the severity of the economic slump.

While no one thinks a severe recession, much less a depression, is likely, a number of analysts cautioned that under present circumstances the Fed will be walking a tightrope. Little if anything has been done so far about the basic forces that were pushing up interest rates -- a fear that the central bank would have to tighten the availability of cash to prevent a further decline in the value of the dollar, or, alternatively, that the dollar would fall and generate a new burst of inflation caused by the lower-valued dollar.

"The Fed is caught in a dilemma," said Lyle Gramley, chief economist of the Mortgage Bankers Association and a former Federal Reserve governor. "It might be wise for it to abandon its move toward monetary restraint" but only if it can do that without recreating the fears that caused it to tighten in the first place, he said.

"It can't act aggressively without renewed downward pressure on the dollar. And it can't act aggressively to avoid a recession. It must move cautiously."

One thing the Fed must look closely for is any indication that the stock market gyrations have so increased investors' uncertainty that they want to build up large holdings of cash and short-term securities as a precautionary move.

Officials at the Fed "have their back to the wall," Gramley declared. "This is a very difficult set of circumstances in which to decide what the proper course for monetary policy is."

The Fed's problems are complicated, he added, by the fact that "the financial markets really don't know {Greenspan} well enough to have confidence in him."

Scott E. Pardee, vice chairman of Yamaichi International (America) and another former senior Fed official, echoed Gramley's view. "Basically, everyone recognizes that the Fed has an impossible job right now. If it eases {the availability of cash}, the dollar will come down and we will have more inflation. If the Fed tightens right now, we will have a recession. The dilemma is more clear now than it was a week ago."

Given the circumstances, Pardee said, "The Fed has done rather well. Greenspan made his statement ... and the {federal} funds rate came down." However, he stressed, "This is not a banking crisis, it is not a liquidity crisis" that requires a massive infusion of funds to relieve. Thus, there is a limited amount the central bank actually can do at the moment.

Indeed, there were sharp disagreements among analysts over precisely how far the Federal Reserve has gone to calm the markets.

Last week, some market participants thought the rising federal funds rate was a sign of a further Fed tightening after its action last month to raise its discount rate from 5.5 percent to 6 percent. The discount rate is the interest rate the Fed charges when it lends funds to financial institutions.

At the time of the discount rate hike, the Fed also chose to make reserves less readily available to the banking system, an action that caused the federal funds rate to go up. But Fed Vice Chairman Manuel Johnson said on Monday that the central bank had not tightened policy since the time it raised the discount rate.

These policy nuances are important in trying to decipher whether market forces or Fed policy moves -- or both -- are responsible for interest rate movements. "Last week there was some market tightening going on," said Pardee, "and clearly there was some overshooting on the funds rate." That is, the market was taking the rate higher than the Fed wished it to be.

Thus, in Pardee's opinion, part of the subsequent drop in the funds rate -- which often is the key to the whole structure of short-term interest rates -- was a simple reversal of that market overshooting. But both the timing and the way in which the Fed has made more cash available to the banking system probably indicate there has been some easing of policy as well. "There is a show of generosity in the operations," Pardee said.

A further sign that market psychology has turned for the moment, at least, is that the rally in the bond market is not just a matter of investors finding a place to park the money they have pulled out of stocks.

"The rally in the bond market has been more of a rally led by {bond} dealers and people who trade government securities," Pardee said, even though there has been some flight to quality in longer-term bonds as well as in Treasury bills and other short-term securities.

Another significant factor contributing to the decline in interest rates has been the patching up of the disagreement between U.S. and West German officials over a trend of rising German interest rates.

After a meeting between Treasury Secretary James A. Baker III and German officials, the West German central bank announced it was lowering slightly a key money market rate it controls.