Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Why the market is losing its faith in the Fed

Market losing faith in the Fed
Market losing faith in the Fed

As the Federal Reserve prepares to exit its monthly money-printing program, it faces a thorny dilemma with a market that is not buying what the central bank is selling.

Fed watchers increasingly are commenting on a dichotomy as it relates to monetary policy—namely, the disparity between what the so-called dot plot is showing regarding individual Open Market Committee members' expectations for its target short-term rate, and what the market believes the actual path will be.

Specifically, the FOMC grid is indicating a more aggressive path than what the market is pricing in.

The dot plot shows FOMC funds rate expectations for 2015-2017 at 1.38 percent, 2.88 percent and 3.75 percent respectively. Market expectations, as judged by futures action, are for 0.45 percent, 1.35 percent and 2 percent, according to economists at Deutsche Bank.

In short, investors simply don't believe the Fed and instead envision a scenario in which rates rise much more gradually.

Clarity from the Fed?
Clarity from the Fed?

In some respects, this is the Fed's worst scenario, in which its dithering over rate policy and mixed public signals cause it to lose credibility, a situation that could create substantial market dislocations considering soaring prices of risk assets over the past 5½ years.

Read MoreWhat traders are watching while they wait for the Fed

Joe LaVorgna, Deutsche's chief U.S. economist, and others at the firm said in a note that there are three reasons why the market disagrees with the Fed's forecast:

One, financial market participants do not believe the Fed's real GDP, unemployment and inflation forecasts. Instead, investors believe that growth and inflation will remain modest, which means the Fed will be very slow in raising interest rates.

Two, the markets believe that Chair (Janet) Yellen is extremely dovish. In essence, her "dot" on the FOMC histogram is at the bottom end of the range.

The third reason may simply be that the financial markets do not believe what the Fed says it is going to do in the future.

Each reason has it's own level of credibility: The Fed historically has done a poor job with its economic forecasts, especially with gross domestic product; Yellen, a policy dove, has done an impressive job so far forging a coalition on the committee and has openly expressed her desire to stay low for longer; and the Fed has moved the goalposts several times already in terms of what economic triggers would cause an end to quantitative easing and especially for rate hikes.

As LaVorgna pointed out, former Fed Chairman Ben Bernanke in mid-2013 initially had indicated the "tapering" process, or the reduction in the Fed's monthly bond-buying program known as QE, likely would start after the unemployment rate broke below 7.5 percent.

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That, of course, didn't happen due in large part to the infamous "taper tantrum" of market tumult—slumping stocks and rising rates—with the actual reductions not starting until several months later.

Since then, there has been a series of Fed head fakes. Yellen herself jolted the markets at her initial news conference in March, during which she indicated that rate hikes could happen as a soon as six months after the end of QE.

The FOMC also has tossed aside data benchmarks like 6.5 percent unemployment and 2.5 percent inflation as indicators for when rate hikes would start, relying now on language that says the decision will be "data dependent" without specifying which data or what levels any of the various points would have to hit.

At what is likely to be an otherwise uneventful meeting, the FOMC on Wednesday is expected to announce the well-telegraphed end of QE3. But with this Fed, nothing seems to be written in stone.

Read MoreWall Street less confident than Main St. investors

St. Louis Fed President James Bullard kicked off a rally on Wall Street two weeks ago when he suggested that the Fed should delay the exit until inflation picks up.

LaVorgna said the market is justifiably skeptical of Fed pronouncements:

Ultimately, the path of interest rates will depend on the economy's spare capacity. If inflation and wage pressures develop over the next several quarters, then the Fed's interest rate forecasts are likely to be realized. If, however, inflation remains well below 2 percent as the economy expands and the unemployment rate falls, then financial markets will be proven correct.