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The Standard and Poor's 500 stock index and the Dow Jones Industrial index hit record highs yesterday. Note also that European stocks were trading around five-year highs. This achievement is being assumed by almost everyone that investors believe that the Federal Reserve will continue to purchase $85 billion in securities every month for the near term.

Dave Shellock writes in the Financial Times this morning,

"Underpinning the gains for US and European equities was the expectation that the Fed would opt to maintain the current level of its stimulus measures for some time to come."

The "market" was surprised last month that the Federal Reserve did not begin to taper after its last meeting because of economic information that did not indicate the economy was picking up significantly to warrant a reduction in purchases.

This month we have the government's shutdown to thank for further postponement of the tapering of purchases because of the uncertainty the shutdown will have on economic activity and labor hiring.

Most analysts are stating that the Fed will not reduce or taper its purchases until at least next March. The reason for this is that Mr. Bernanke leaves his post as Chairman of the Board of Governors of the Federal Reserve System in January. Presumably Janet Yellen will take over the post at that time.

People are giving the Fed two months to absorb the ascendancy of the new Chair and to obtain year-end data before any change in the purchasing program is made. Thus, March is assumed to be the first month that it is really reasonable to expect that a change in purchases might take place.

So, the stock market continues to rise.

But, at one level, doesn't this sound contradictory.

The Federal Reserve is expected to continue its quantitative easing because economic growth is so mediocre, profits are not robust, unemployment is not dropping fast enough, consumer confidence is falling, and there is no pressure for prices to rise.

If this the expectation of people at the Federal Reserve and the investment community buys onto this view of the progress of the economy, what is it that is propelling stock prices on to achieve new highs?

If the answer to this question is that stock prices are gaining new highs because the Federal Reserve is going to continue to buy $85 billion in securities every month for at least another five months then, all I can say to this conclusion is… the increase in stock prices seems like a bubble to me.

If economic growth and corporate performance are not there… and are not expected to be there… what is the reason for the rise in stock prices?

Federal Reserve liquidity?

Where is the economic justification for the movement in stocks? Is the movement based on the assumption that the actions of the Federal Reserve will bring on better real economic conditions in the future?

It does not seem highly likely that this third round of quantitative easing on the part of the Fed is going to do much more to spur on economic growth given the failures of the first two rounds to produce more a more robust recovery.

An additional factor to consider in this equation is how the expected actions of the Federal Reserve is playing out in the foreign exchange markets. Although the value of the euro against the dollar dropped at the end of trading yesterday, earlier in the day the euro traded in excess of $1.38 during the day and has been around this price from much of the past week. One has to go back a couple of years to see the price at this level.

And, in terms of the value of the dollar against other major currencies in the world, the Federal Reserve index shows that the value of the dollar is approaching the lows of the past seven years.

This weakness in the value of the dollar underwrites the conclusion that investors see the credit inflation created by the Federal Reserve as having a greater impact on nominal values rather than on real values.

This conclusion is consistent with the view that stock prices can rise in the future without supporting evidence that real economic growth and profits will increase to justify the increases.

In the meantime, the Federal Reserve continues to underwrite the inflation of asset prices, hoping that someday the real economy will get its act in order and begin to show greater vitality.

Source: Stock Market Votes That Federal Reserve Will Continue Purchases