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The Fed slipped this one past the market—what's up?

Amid all the "sound and fury" about the tightening monetary policy in the United States, the Federal Reserve slipped by the napping market vigilantes one of the largest monthly expansions of its balance sheet on record.

In the course of February, the Fed's monetary base expanded by a whopping $104.8 billion, the third-largest monthly increase since the beginning of its asset purchases.

This month looks like it could well be more of the same. During the reserves reporting period between February 19 and March 5, the high-powered money soared by nearly $30 billion, bringing the year-over-year increase to an incredible 36 percent.

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No wonder the yield on the benchmark 10-year Treasury note finished at 2.65 percent last Friday, after several flare-ups in the 2.70-2.75 percent range over the last month-and-a-half.

The Fed's printing presses have also been good for equity markets: The S&P 500 gained 4 percent since late January.

(Read more: Yellen sees better economy, less money printing)

Foreign bond sales and weak economy

This latest surge in Fed's monetary creation comes after three months of a significant slowdown in the rate of expansion of its record-high $3.9 trillion balance sheet. Indeed, monthly increases in the monetary base between November and January were brought down from $95 billion to $11 billion.

The question is: What caused this sharp policy reversal since the end of January? There are two explanations.

The first is the yet unconfirmed story that the Fed was picking up Treasury securities that were allegedly dumped by the Russians and the Chinese. The official statistics are not out, but these are the guesses because both governments have been net sellers of American debt instruments during the fourth quarter of last year.

The other explanation has to do with the lingering weakness of the U.S. economy.

In spite of a strong acceleration in the second half of last year to an annual growth rate of 2.3 percent, from a puny 1.5 percent in the first six months, a big slack in labor and product markets is leaving the economy well below its noninflationary growth potential of about 3 percent.

The labor market data for February show little change in the number of people out of work and in the unemployment rate. Adding the involuntary part-time workers and those who dropped out of the labor force (because they could not find a job) to the recorded jobless numbers brings the actual unemployment rate to more than 13 percent, double the officially reported rate of 6.7 percent.

Particularly worrying is a huge jump last month in the long-term unemployed — people looking for work for more than six months. They now represent 37 percent of the total number of people without a job (i.e., 3.8 million).

Fed Chair Janet Yellen has talked about that with great empathy.

But apart from that laudable concern of a public servant, she also knows that the Fed is falling short of its mandate with respect to economic growth and employment at a time of particularly quiescent price inflation (1.6 percent in January).

Clearly, the Fed is operating in an environment of a large output gap and has quite a bit of room to maintain easy credit conditions.

A sense of measure is needed, though. I don't believe, for instance, that a policy characterized by a negative real federal funds rate of minus 1 percent should also include large monthly asset purchases. In addition to being a thinly disguised outright monetization of public debt, that is also an unnecessary and flagrant distortion of U.S. financial markets. And none of that is a reassuring example of monetary management in a country whose currency serves as a transaction medium and reserve asset in the rest of the world.

(Read more: Fed at crossroads: Transcripts detail crisis)

Investment implications

I am sure that the Fed will continue its easy monetary policy for the rest of this year, but the direct support of the bond market is a separate issue.

If it does turn out that foreign investors are becoming aggressive net sellers of U.S. bonds (possibly in retaliation for U.S. economic and financial sanctions), then the Fed could be expected to mop up the ensuing excess supply of Treasury securities to moderate upward pressures on long-term interest rates. But in the absence of such events, I think it is a reasonable bet that the Fed will gradually reduce its monthly asset purchases to allow the bond market to respond to economic activity and inflation expectations.

Things are much clearer with regard to the U.S. equity market. Ample and expanding liquidity will continue to drive stock market valuations. A sustained economic growth, cyclically-induced productivity gains and subdued real wages will also underpin corporate earnings. These factors have led to an increase of more than 5 percent in the profits of American companies during the first nine months of last year (latest observation points available).

Gold will continue to do well on geopolitical tensions and asset diversification of some major central banks.

(Read more: Fed's Plosser 'very worried' about QE consequences)

A longer-term investment focus should be on U.S. inflation. At the moment, inflation worries are unwarranted. With a zero growth in real hourly compensations in the nonfarm business sector, declining unit labor costs and a large slack in labor markets we are still far from the beginning of a sustained increase in the federal funds rate.

Follow the author on Twitter @msiglobal9

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