Is Stage Set For Markets To Again Be Smarter Than The Fed?

The Federal Reserve's dual mandate, established by Congress, is to maintain economic growth, while avoiding excessive inflation.

It attempts to do so by shifting back and forth between tight money policies and easy money policies, hiking or lowering interest rates, depending on whether the economy is in need of stimulus, or is growing at a pace that threatens rising inflation.

It has another tool that is just as important, 'jaw-boning'. That is, through interviews, in speeches, FOMC statements, or testimony before Congress, the Fed provides positive assurances and rosy economic projections when needed to encourage consumer and business spending, as well as investors.

Unfortunately, in each cycle, the Fed eventually winds up 'behind the curve', still providing positive guidance even after economic conditions have turned sour.

At that stage, when the reality no longer supports the Fed's optimism, it does not fool markets for long. They often have bear markets underway well before the Fed admits the changed conditions.

There are far too many examples to cite. But for example, in May 2000, with the 2000-2002 bear market already underway, then Fed Chairman Alan Greenspan was still saying, "Economic growth is enhanced by the kinds of financial innovation that technology and deregulation are now producing."

As the housing bubble burst in 2006, Fed Chairman Bernanke assured us that "Our assessment is that this looks to be a very orderly and moderate kind of cooling."

In 2007, when it could no longer be denied that it had been a bubble which had burst, and as the economy headed toward the 2008 financial meltdown, he said, "Our assessment is that there's not much indication that subprime mortgage issues will spread into the broader mortgage market, which still seems healthy."

In January 2008, with the 'Great Recession' already underway, Bernanke said, "The Federal Reserve is not currently forecasting a recession."

In June 2008, as the economy and stock market rolled over into the second and worst downleg, Bernanke said, "The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so."

This week, the Fed surprised markets and analysts, the majority of whom expected the Fed would have to acknowledge in its FOMC statement that both the economic slowdown and rising inflation have become problematic.

Instead, the Fed said, "Economic activity has rebounded since our last meeting [in March]. And, "Inflation has been running below the Committee's longer-run objective of 2.0%."

In spite of evidence that the housing industry is in deepening trouble, likely to be a serious drag on the economy, the Fed's reference to housing was only that "the recovery in the housing sector remained slow."

Asked in her press conference about the problems in the economy, Fed Chair Yellen said, "I don't see the kinds of trends that would suggest to me that the level of financial stability risks has risen above a moderate level," and that the slowdown since last fall, negative GDP growth in the 1st quarter, and downgrades for the 2nd quarter and the rest of the year, are only "due to transitory factors . . . . there are good reasons to see sustained growth."

Asked how, in the face of Consumer Price Index inflation having run at 2.1% over the last 12 months, the Fed can claim that inflation is running below the Fed's objective of 2% (and won't reach 2% until 2015 or 2016), Yellen brushed off the evidence of rising inflation as just "noise" in the data.

Matthew Hornbach, managing director at Morgan Stanley, says, "The Fed's characterization of recent inflation readings as 'noisy', in spite of the preponderance of evidence, leaves us feeling the Fed is likely to now dismiss most economic data deviations."

So, has the Fed reached the typical point in this cycle where its optimistic projections will continue, but fly in the face of the facts, and will not fool markets?

The gold market, the historical hedge against inflation, has already spoken, spiking up a huge $50 an ounce in reaction to the Fed's denial that inflation is rising.

Will the stock market soon have a similar reaction to the Fed's assessment that, in spite of evidence to the contrary, "there are good reasons to see sustained growth," and that the housing recovery continues and merely "remains slow"?

Because, this week's reports from the housing industry were more of the same, indicating no recovery from the supposedly weather-induced winter slowdown.

New housing starts fell 6.5% in May. Permits for future starts fell 6.4%, to a four month low. The Housing Market Index, measuring the confidence of home-builders, showed the majority remains pessimistic in June. And applications for mortgages fell 9.2% last week.

So even as spring weather progresses, the housing reports become ever more negative.

Meanwhile, with new data available from other areas of the economy, it is now expected first quarter GDP will be revised down further into negative territory, perhaps as low as -1.9%, and second quarter forecasts are being revised down rapidly.

In recent days the World Bank cut its forecast for global growth sharply, and this time cited the U.S. economy as likely to be one of the main drags. This week, the International Monetary Fund cut its forecast for the U.S. economy again, now forecasting only 2.0% growth for the year, down from 2.7%.

And at its FOMC meeting this week, the Fed itself, while providing its rosy outlook, also cut its forecast for 2014 sharply, to 2.1 to 2.3% growth, down from its forecast just two months ago of 2.8 to 3%.

So again, the question. With the market potentially overvalued, investor sentiment and participation at extremes of complacency and bullishness, insiders selling heavily, is that other situation usually seen at market tops, the Fed being behind the curve with its optimism, also flashing a warning?