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NEW YORK (CNN/Money) - The Federal Reserve raised rates by a quarter point on Tuesday, the eighth increase in nearly a year.

Many investors worry that the Fed's pattern of steady increases signals stagflation. The continued pick up in inflation is inevitable, that theory has it, and the Fed will have to keep hiking rates to rein it in. The collateral damage will be a sudden drop-off in economic growth.

In this scenario, the best possible outcome is mild stagflation. Growth would run less than 2.7 percent a year, and inflation -- up 3.1 percent over the past 12 months -- would keep creeping upward.

Achieving even that requires Fed chairman Alan Greenspan to walk a tightrope. If he raises rates too much, the economy will actually go into recession. And if he is too passive and doesn't raise rates enough, inflation will surge far faster and cripple the long-term economy.

In my view, this analysis of current Fed policy is fundamentally mistaken.

They key thing to realize is that the Fed is not tightening. It is actually following increases in interest rates that have already occurred in the money markets.

The market interest rate on three-month Treasury bills started up in early May of last year. Since then, T-bill yields have risen 1.9 percentage points.

The Fed, by contrast, began raising the funds rate in late June and has since increased it by 1.8 percentage points. Conclusion: There is no evidence that the Fed is moving faster than the market or getting out way ahead of the rise in market interest rates.

This conclusion is confirmed by the behavior of long-term rates. Yields on 10-year bonds were close to a peak just before the Fed began raising short-term rates. Since then, however, 10-year bond yields have actually fallen by more than half a percentage point.

This drop is a sign that the bond market is not experiencing a credit squeeze but rather regards the Fed's moves to date as prudent anti-inflationary policy.

Where does the Fed go from here? Another quarter-point increase this week would put the Fed slightly ahead of the market, with a Fed funds rate of 3 percent. But some analysts believe that the Fed could raise rates to 3.25 percent, or even 3.5 percent, without cramping the economy.

Assuming the Fed stays within those bounds, the outlook for stocks will depend almost entirely on economic developments, rather than Fed policy. And the pros and cons of the economy are fairly clear.

In the first three months of the year, the economy grew an annualized 3.1 percent, the weakest rate in two years. On the other hand, that figure is the eighth straight quarter of above-average growth (even if it's not much above average).

It's hard to see how the U.S. economy can be on course for stagflation, when growth is above the historical norm yet not so high as to stoke inflation.

Moreover, while unemployment has come down half a percentage point over the past year, at 5.2 percent it isn't low enough to promote intense wage inflation.

Overall, the economy is chugging along but not likely to overheat and reignite an inflation spiral.

The bad news is that the probability of external shocks remains extremely high. Another upward spike in the oil price could add inflationary pressures no matter what the domestic economy looks like.

The risk of terrorism is also still scary. And the budget deficit, combined with the intractability of problems such as Social Security, causes many worries about the future.

The best portfolio strategy in such a situation is to recognize the relatively high risk of unpleasant surprises and keep your portfolio defensive. That means diversifying as broadly as possible and including plenty of conservative investments such as high-yield stocks.

But also recognize that defensive investments are fully valued today. The bargains right now are among the big-cap growth stocks -- and especially technology -- because those are precisely the companies that would suffer most in a stagflation.

That stagflation, however, is nowhere to be seen. The real risks will depend on the way external events unfold.

Be as defensive as you feel you need to be, but also make some room in your portfolio for today's great growth bargains. The Money 50, Money magazine's annual list of top mutual funds, includes a number of large cap offerings that favor growth. See the list here.

Sivy on Stocks resources:

Sivy 70: America's best stocks

Guide to Growth

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Michael Sivy is an editor-at-large for MONEY magazine. Click here to receive Sivy on Stocks via e-mail every Monday.