Money mystery deepens.

PERHAPS IT'S wishful thinking, but while calling the usual suspects for comment in the aftermath of the discount-rate increase from 6 per cent to 61/2 per cent on August 9, 1 seemed to detect a certain weariness with the whole process. The financial community is deeply divided about whether inflation is returning-and, unusually, this dispute is not merely a rationalization of partisan preferences but can be found right across the political spectrum. There is a widespread rueful awareness that no theory of monetary policy has performed particularly well in recent years. As a result, most factions tend to acquiesce grudgingly in the policy of Fed Chairman Alan Greenspan, although no one is sure exactly what it is.

Now, finding the Federal Reserve at the heart of the otherwise basically free U.S. economy is an anomaly rather like finding the bones of a sacrificed virgin beneath the altar of a Christian church. The Fed is a central bank, albeit a peculiarly American version, since, unlike the central banks of other industrialized nations, it is not a government agency but a government-enforced cartel technically owned by the major commercial banks. Organized only in December 1913-more than a year younger than one of its most relentless critics, Nobel economics laureate Milton Friedman-the Fed, like modern public education, is part of the legacy of the Progressive Era, another of America's periodic spasms of faith. in the efficacy of government intervention.

The Fed is supposed to control the supply of money and credit in order to prevent disturbances in the economy like inflation, deflation, and depression. But it is a matter of historical record that since the Fed appeared on the scene, economic disturbances have actually been more serious than previously-notably the Great Depression of 1929-33 and the Great Inflation of the 1970s.

The Fed attempts to exert its control through three principal mechanisms: injecting or withdrawing reserves from the banking system by buying or selling government bonds; taking regulatory action, such as changing reserve requirements (the balances it requires banks to maintain to back up their outstanding loans); and altering the discount rate (the rate at which it will loan reserves to banks). Money and credit, however, are not passive. They fluctuate according to people's willingness to lend or hold cash. So the discount rate, for example, is what economists call an administered price: one that can be controlled in the short run but that is ultimately determined by market forces.

For most of the time since the Depression, the Fed had the idea it could fine-tune the level of demand in the economy. It focused on interest ratesthe price of credit-assuming that the amount of money it was supplying was less important. But interest rates are affected by many factors, and the Fed often ended up supplying so much money to the economy that it boiled off into inflation.

By the time the Fed finally admitted the importance of the money supply in the late 1970s, however, the demand for money-its "velocity of circulation"-turned out to be jumping about unpredictably too. Thus, judged by the usual measures, the Fed supplied massive quantities of money to the economy after 1982. But, contrary to the predictions of monetarists like Milton Friedman, who had long argued that the Fed should quit finetuning and supply money in steady and moderate quantities, the economy absorbed it. There was no inflation explosion-at least at that time.

It's rather unfair that the monetarists' failure to predict the inflation rate in the mid 1980s has been allowed to obscure their far greater triumph in establishing that the Great Inflation of the 1970s could indeed be broken by monetary discipline: that, in short, money matters. It's the kind of thing that makes you suspect that the economics profession might be dominated by political liberals who are blindly allergic to the monetarists' conservative and free-market associations. But the fact remains that neither a price rule nor a quantity rule for monetary policy has proved wholly satisfactory. So now the Fed seems to be flying blind, responding to ad-hoc considerations such as the state of the economy and the behavior of key prices.

AFTER 1985, with inflation declining to around 2 to 3 per cent a year and with Jim Baker at Treasury, the most important ad-hoc consideration apparently became the exchange rate. Politicians (and markets, it must be admitted) can only focus on one number at once. They stopped worrying about inflation and started worrying about the trade deficit, spurred on by pitiful cries from manufacturers who found themselves unable to compete with cheap imports, Imports were cheap because the dollar was enormously strong. From a freemarket standpoint, this was a problem that would correct itself: the dollar would eventually fall, and quite possibly there would also be a reallocation of resources within the U.S. from traditional to newer, more competitive industries. But Baker, no doubt regarding this as impractical theorizing, embarked on a policy of negotiating with our trading partners to hold down the dollar in relation to their currencies.

One thing about last October's stock-market crash: it stopped politicians worrying about the trade deficit. Sheer terror about possible economic collapse now headed the agenda. But it was at about this point that American exports started to pick up, exactly as predicted by those who believed the problem was self-correcting. And by the middle of 1988, it became clear that the world was not collapsing into recession.

Instead, something quite unusual had occurred: all the major industrial economies were expanding strongly at the same time. Interest rates were rising everywhere-partly because that's what interest rates do when demands for credit increase, but perhaps also because central bankers seem to have decided they want a stable dollar in this election year and have therefore moved to check its rebound by raising their own rates. After all their moaning about Reaganomics, they are voting Republican with their currencies. Apparently they fear Dukakonomics (that is, AFL-ClOnomics, a/k/a protectionism) even more.

What about domestic politics? In terms of contending economic ideologies, of course, none is dominant. One reason the recent discount-rate hike surprised people is that it directly contradicted earlier comments by one Fed governor, Manuel H. Johnson, suggesting that the Fed had finally decided on specific market symptoms by which to guide its policy (commodity prices, the exchange rate, aspects of the debt market). Apparently, this report was premature. For none of these symptoms indicated that a rate increase was particularly necessary on August 9.

In terms of partisan politics, the fact that the economy has resolutely continued to expand obviously reduces the Administration's desire to put pressure on the Fed. And from a technical point of view, the dilemma the Fed faces is sufficiently difficult to deter most meddlers. Inflation is thought to be picking up, but the indices may be distorted by random events like the drought. (Price increases as a result of things like droughts don't count as inflation, since people simply have less money to spend on other things. Inflation is a generalized rise in the price level.) It's also possible, as some Wall Streeters maintain, that inflation fears are overdone. The recent fall in the price of gold is a powerful endorsement of that argument. And if the Fed raises rates sharply to choke off inflation, it might trigger a rise in the dollar, raising import prices irritatingly, or -horrors! -precipitating another stockmarket crash.

Curiously, both believers and skeptics on the subject of inflation are generally favorable to Greenspan, the former because he is raising rates, the latter because he is doing so rather slowly. In fact, the only real winner in the economic wars of the last few years is the office of Fed chairman. It used to be taken for granted that presidential-election years would see monetary looseness and a surging stock market. But recently Volcker and now Greenspan seem to have found the right combination of hope and horror to hold the politicians at bay.

But life is not unimaginable without a Federal Reserve. Indeed, Milton Friedman's latest proposal is to freeze the monetary base and deregulate the banking industry, allowing credit to be completely determined by market forces. So the only real question is whether this endless melodrama is worth while.