Can Federal Reserve be made to rein in interest rates?

Ever since its creation by Congress in 1913, the Federal Reserve System has presided over the shadowy magic of monetary policy as a quasi-independent branch of government. Theoretically, the Fed's autonomy prevents the money supply from being manipulated for crass political purposes.

Over the years, politicians have mounted sporadic attempts to curtail some of the Federal Reserve's flexibility, complaining that the central bank showed a regal lack of interest in the occasionally painful results of its policy.

Now the Democratic leadership on Capitol Hill has put forward the most specific proposals ever for bringing the Fed to heel. Bills pending in both chambers of Congress would require the Fed to control ''real'' interest (interest rates minus the rate of inflation).

''It is time for Congress to wrest control of monetary policy from the hands of a tiny band of monetary ideologues,'' said Sen. Robert C. Byrd (D) of West Virginia in introducing the legislation.

''This is a perfect example of why you need a central bank with a degree of independence,'' rejoins Frederick H. Schultz, vice-chairman of the Fed until early this year.

The Balanced Monetary Policy Act of 1982 (subtitled ''a Democratic recovery initiative'') would require the nation's central bank to aim at annual targets for real interest rates ''consistent with historic levels.''

Historically, US real interest rates have fluctuated between 1 and 4 percent. But over the past two years, as the Fed clamped down on the money supply in an effort to smother inflation, real interest rates have shot up to record highs: between 1979 and '81, the ''real'' prime rate averaged 6.5 percent.

The Democratic bill would require the Fed to wrench these rates back down by easing its tight-fisted grip on money. The result, supporters say, would be an upturn in the economy - without an inflationary spurt in the money supply.

''Nobody's talking about loose money,'' says a staff member with the Democratic Policy Committee, which shaped the legislation. ''Historically, what we're talking about is not loose at all.''

Until recently, the Federal Reserve spent most of its time trying to control nominal interest rates. In October 1979, it abandoned the effort and switched to primarily watching measures of the amount of money in circulation.

''We see this bill as taking the pendulum and swinging it about halfway back'' to the Federal Reserve's pre-1979 operating procedures, the Democratic aide says.

A spokesman for the Fed declined to comment on the legislation, saying only that it would make a public statement if asked to testify on Capitol Hill. He did add that the effort was apparently ''the most specific proposal yet'' aimed at curtailing the Fed's operating independence.

But to critics the bill is nothing but blatant politics, most difficult to pass, almost impossible to be carried out.

''One reason we got into trouble in the first place was the belief that the Fed could peg (money supply and interest rates) simultaneously,'' says Dr. Robert Davis, a vice-president at Harris Bank in Chicago, considered a hotbed of monetarist thought. Dr. Davis sees similar thinking reflected in this legislation.

Others say the bill is somewhat akin to passing legislation aimed at improving the weather - well intentioned but ineffective.

''Their argument assumes the Fed can get interest rates down by overtly injecting a lot of reserves into the monetary system,'' says Mr. Schultz, who now runs his own investment firm in Florida. ''That is just not the case.''

Instead, Schultz says, financial markets would simply assume the Fed was once again bowing to political pressure and giving up on controlling inflation. Reflecting this expectation, long-term interest rates would rise, not fall, if the bill passed, he says.

''You could explain (how this is not really loose money) until the cows come home, and the markets would still see it as giving up on the fight against inflation,'' he adds.

The bill is ''as good an example as you could find'' of the Fed's need to be insulated from the buffeting, quickly changing winds of the political process, says Schultz, as it would sacrifice the long-term inflation fight for short-term gain.

He says what is really needed is tighter fiscal policy. Then, the whole burden of curbing rising prices wouldn't fall on the Fed's shoulders.

The bill's backers say Mr. Schultz is simply demonstrating the Fed's baronial haughtiness about the effects of its policies on jobs and gross national product.

The Federal Reserve ''has developed a tradition of secrecy that can only be harmful to public trust and ultimately to our economy,'' Senator Byrd said in introducing the bill in the Senate.

No Senate hearings are scheduled. The House Banking Committee will hold hearings soon after the August recess - and the chairman, Rep. Fernand J. St Germain (D) of Rhode Island, hopes to report out a bill in time for a floor vote before the current congressional session is over.

Ironically, hard-line Republicans often take a position on this issue close to that of the Democratic leadership. In March, Sen. Dan Quayle (R) of Indiana introduced a ''sense of Congress'' resolution calling for the Fed to stabilize real interest rates at historic levels - and such Republican gold-standard advocates as Lewis Lehrman, who is running for governor of New York, take a similar stand.