Federal Reserve Board Chair Janet Yellen said Wednesday that the central bank plans to keep interest rates at a record low "for a considerable period." (Reuters/Gary Cameron )
(Reuters/Gary Cameron )

Markets sure seem to think that the Federal Reserve has made a big mistake.

It hasn't just been stocks selling off 10 percent to start the year. It has also been bonds saying that they don't think the Fed will come close to hitting its target of 2 percent annual inflation anytime in the next 10 years. Markets, in other words, have done everything short of holding a boom box outside of Fed Chair Janet Yellen's window to beg her not to raise interest rates any more after the Fed hiked them in December for the first time in nearly a decade. And it just might work. After all, there's no such thing as an atheist in a foxhole or an inflation hawk in a stock market crash, especially when prices were barely rising to begin with.

Why is that? Well, the stock market might be the worst way to tell the future, except for all the others. So even if, as the old joke goes, it's predicted nine out of the last five recessions, that's still a lot better than predicting zero out of the last 220. That, as Larry Summers points out, is how many the International Monetary Fund has seen coming at least a year in advance. The fact, then, that the S&P 500 seems to be saying that the recovery is falling apart should make even the most committed inflation-fighter wonder whether there is actually anything to fight.

It's generally not a good thing when the stock market says you might have to start cutting rates right after you started raising them.

So will the economy fall into recession? On the one hand, it's hard to see how the economy could be heading that way when it's been adding an average of 284,000 jobs the last three months. Sure, the oil crash has hurt drillers and the strong dollar has hamstrung manufacturers, but lower prices at the pump should be putting enough money in people's pockets to make up for that—right? Well, probably.

On the other hand, though, things still seem fragile enough that it wouldn't take a lot of bad news to turn our slow-and-steady recovery into none at all. Maybe shale producers will cut back more than consumers step-up their spending. Or maybe a slowdown that, like so many other things, has been made in China will get exported to us. Or maybe—and this is the big one—the Fed will continue to increase interest rates when it probably shouldn't. There might only be a 20 percent chance that these would add up to the r-word, but even that is too big to ignore.

This last one is what matters most. The main reason we'd fall into a recession is if the Fed either pushes us or allows us to be pushed into one. Think about it like this. Ever since the recovery was just learning to walk, the rest of the world has been putting hurdles in front of it. First it was the euro crisis, then the Japanese tsunami, then the euro crisis, then triple-digit oil prices, then the euro crisis, then China's slowdown, then the euro crisis again, and finally China's even bigger slowdown. So why hasn't the economy stumbled over any of these? Because the Fed has tried to stop that from happening. It did a round of quantitative easing in 2010, Operation Twist in 2011, and an even bigger round of quantitative easing in 2012 all to keep the recovery on track. But now it's cutting back on stimulus rather than amping it up, leaving the economy more vulnerable.

And it's been cutting back even though the economic case for doing so isn't that strong. The Fed raised rates in December because it thought the fact that unemployment is pretty normal means that inflation would eventually pick up too, and it wanted to make sure it didn't rise too much. The only problem is there isn't any evidence of that so far. As I mentioned, markets now think that the Fed will undershoot its inflation target as far out as the five years from 2021 to 2026 by even more than they used to. Now, a big part of that is due to the continued decline in oil prices, but that's actually not much of a consolation. It just means the Fed has convinced people that it will continue to raise rates in the face of well below-target inflation. Indeed, it keeps telling anyone who will listen that, with inflation at just 0.4 percent, it hopes to raise rates four times this year.

It doesn't have to, though. The sell-off, Morgan Stanley says, has already tightened financial conditions as much as four rate hikes would. And that's why raising rates 0.25 percentage points has had an impact of something much larger than 0.25 percentage points. This is an important point. Sometimes increasing interest rates increases them by more than you increased them by. And sometimes you don't even have to increase them to actually increase them. Still with me? All that means is that what the Fed says matters just as much, if not more, than what it does. So if it raises rates and hints that there are more to come, markets will send slightly longer-term rates up by more than that. And if it doesn't raise rates at all, but says it will soon, well, you get the idea.

The upshot is that the Fed has been tightening policy a lot longer than you think. All you have to do is look at 2-year borrowing costs. Those are short-term enough that the Fed still has a fair amount of control over them, but long-term enough that they move more than the Fed's benchmark funds rate has. And it turns out that the Fed began to tighten not when it increased rates in December, but rather when it talked about decreasing its bond-buying in May 2013. That's when 2-year bond yields jumped up, something they have continued to do for two and a half years now. Now, if you asked someone at the Fed about this, they would probably say you're crazy. Not buying as many bonds as before is still buying more bonds, which, according to every one of their models, should mean that money was getting more stimulative, not tighter. But that's not how markets interpreted it. Sure, the Fed was buying more bonds, but it wasn't as many more as markets thought it would be—so, from a certain point of view, it was less. Then they continued to edge up after that as the Fed basically kept saying that it wanted to raise rates but wouldn't just quite yet.

If the recovery does come to a premature end, then, it won't be because of low oil prices or China or whatever else you might hear. It will be the same old story: a Federal Reserve that underestimated how much it had already tightened policy, and overestimated how strong the economy really was.

The good thing about mistakes, though, is that you don't have to keep making them.