A pedestrian walks past the Marriner S. Eccles Federal Reserve building in Washington, D.C., U.S., on December 15, 2015.
A pedestrian walks past the Marriner S. Eccles Federal Reserve building in Washington, D.C., U.S., on December 15, 2015. Andrew Harrer—Bloomberg via Getty Images

Did the Fed Make a Huge Mistake by Raising Interest Rates?

Mar 15, 2016

Things seemed so clear in December, when the Federal Reserve raised short term interest rates for the first time in nearly a decade.

For months, investors, economists, and policy mavens had been clamoring for the Fed to raise or "normalize" rates, given signs that the U.S. economy was finally getting into gear. Plus, the argument went, what harm could a tiny quarter of a percentage point hike in rates cause the economy?

Well, almost immediately after the Fed pulled the trigger, the global economy started to slip out of gear. China's economy and stock market began to crack, stoking fears that even the U.S. economy could be at risk of another recession.

From the time of the rate hike through mid February, the Standard & Poor's 500 index of U.S. stocks sank nearly 11% while Chinese stocks lost more than twice as much.

Fast forward to today.

Will the Fed raise rates when policy makers meet again this afternoon? Once again, things seem clear — though in a different way.

Late last year, economists began predicting that the Fed would gradually raise rates four times in 2016. But recent events and market jitters seem to have made those forecasts irrelevant.

"Market volatility and statements by Fed officials in response have convinced the markets that no move is likely at this meeting, making four increases this year highly unlikely," says David Kelly, chief global strategist at J.P. Morgan Funds.

Complicating matters is the fact that since mid February, global economic fears have finally begun to ease as oil prices have stabilized and investor confidence has rebounded. Since Feb. 11, the stock market has jumped about 10%, recouping most of the losses suffered earlier this year.

So did the Fed make a mistake in December after all? Or are we on a stable course for reasonable economic growth — in which case could the Fed be making the opposite mistake today?

Here are the outlines of the debate, and what you should do about it.

Argument #1: The Fed Did the Right Thing

If you are one of the poor souls who reads Fed statements, you'll be familiar with the following words: "Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability."

Jobs and inflation — that's the Fed's job. And on that score, it's hard to argue with the Fed's decision.

Over the past three months employers have added an average of 228,000 jobs per month, while the unemployment rate has dipped to 4.9%. Last month's jobs report signaled an especially positive development: the labor force participation rate, which has been dipping for more than a decade, increased and is up half a percentage point since September.

What this means is that there are fewer discouraged and marginally attached workers than this time last year. Long-term unemployment is improving and more people are quitting their jobs in the hopes of getting a better one.

The Fed has actually had a harder time getting inflation off the ground than healing the labor market. Prices, especially excluding volatile energy and food items, have risen below the Fed's targeted 2% rate, thanks to a number of factors including an underwhelming recovery from the worst economic disaster in nearly a century.

But since last fall, prices have started to rise. Core inflation stood at 2.2% in January, up from 1.7% last May. Moreover, oil prices have seemed to rebound off lows. Plus all those market jitters to start the year have seemed to dissipated, setting the stage for more interest rate hikes in the future.

"I expect the recovery to continue," labor market expert Alan Krueger told Marketwatch. "Moving at deliberate pace means moving rates up two or three times in 2016."

Argument #2: The Fed Did the Wrong Thing

While trend lines might be moving in the right direction, the economy is still a ways off from lift-off, and certainly not strong enough to bear a series of rate increases.

The labor market might be improving, but paychecks aren't. Wages are only slightly growing faster than inflation, and still rest well below pre-recession levels. The economic cost index, which takes into account benefits as wells as earnings, gained only 2.1% in the last three months in 2015. And despite wonderful gains, there are still dramatically more marginally attached and long-term unemployed workers than in 2007.

Likewise, inflation still has a way to go. The Fed's preferred metric still shows prices rising below the target levels, and lackluster wage growth isn't helping matters. Moreover, since inflation was so low for so long, why shouldn't it rest above the target for a period?

Former Treasury Secretary Larry Summers argues that declining prices is a greater risk, anyway. "It seems reasonable to simply suggest that the Fed should run equal risks of over and under shooting its inflation target," notes Summers. "I would actually argue given the observed costs of deflation that the costs of under shooting the target exceed the costs of overshooting it."

As the only hawkish central bank of consequence, the Fed has also crimped the bottom line of U.S. multinational corporations. The dollar has gained against a majority of other major currencies over the past six months. Companies, including Apple, expect lower earnings this year given the strong dollar. (To be fair, the dollar has weakened given the new year troubles.)

There was no compelling reason, argue those who objected to the Fed's move, to raise rates in December. Why not wait until you see the whites of inflation's eyes?

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What You Should Do

Whether or not the Fed made the right move or not, chances are they're not going to abruptly reverse course. But they're unlikely to quickly raise rates either, given the choppy waters ahead.

What does that mean for your investments?

Whether it's a cause, or an effect, the market has been remarkably fickle since the Fed raised rates in December. "It has recorded 32 trading days in which the [S&P 500] rose or fell by 1% or more, which is nearly twice the average quarterly volatility since 2000," notes S&P U.S. equity strategist Sam Stovall.

Despite calmer heads prevailing, most analysts think a March rate hike is out of the question.

"In many ways, this is a replay of last September, when temporary market volatility in August convinced the Fed to delay the long-overdue start to monetary normalization," notes J.P. Morgan Funds' Kelly. "The markets fooled them once then and seem to have fooled them again in early 2016. In her remarks on Wednesday afternoon, Chair Yellen may well stress that April is, in fact, a live meeting and hint that a June increase is very likely."

Where can investors takes advantage? Wells Capital Management chief investment strategist and economist James Paulsen sees value in commodities. "Should commodity prices be nearing a bottom, investors may want to consider some exposure to real assets in the balance of this recovery," he notes. "In each of the last three U.S. economic recoveries, commodities outperformed the stock market during the latter stages of the recovery."

If you want to add a slight commodity exposure to your portfolio, consider MONEY recommended fund iShares North American Natural Resources , which actually grew 8.3% last month.

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