The Fed's 'costly failure' is leading to a 2017 bear market, economist says

Expert says Fed decision will lead to bear market

Money and credit growth in the U.S. has now become inflationary and is encouraging another bubble in stock markets, according to the chief economist at London-based consultancy firm Lombard Street Research.

"The Fed has put market sentiment before the economy yet again. It is doing U.S. stocks no favors by provoking an unnecessary bubble with its certain subsequent burst," Charles Dumas said in a new research note Thursday, following the decision by the U.S. Federal Reserve to defer its next rate hike.

"The economy is running hot, led by consumers. Productivity growth has slumped to 0.5 percent, meaning GDP (gross domestic product) outpaces potential growth by more than 0.5 percent. With inflation already on target, the Fed is encouraging yet another bubble-bust," he added in the note entitled "Fed's costly failure = 2017 bear market."

Since the global financial crash of 2008, central bank policy has focused on buying up bonds in large quantities and cutting interest rates to record lows. The Fed has since looked to unwind this policy and performed one rate hike at the end of 2015. Many still anticipated another rate hike before the end of the year.

Dumas believes that the Fed "helpfully" aided money growth and borrowing following the crash but is now stoking inflation. Furthermore, the negligible cost of borrowing in this "overheated economy" has boosted corporate borrowing that has not trickled down to the real economy. Instead, large companies are using the cash to buy back a portion of its own shares, he said.

Roubini: Don't see a bubble, see frothiness

Microsoft announced a $40 billion buyback this week, but on the whole the number of companies with buybacks over $1 billion dropped to a 3-year low in the second quarter, according to data released by FactSet this week.

Nonetheless, Dumas believes that these buybacks have caused unusually high valuations in stocks markets that are dependent on artificially cheap money. And the problem could arise when the Fed does indeed continue its rate hiking path, he added.

"When the Fed gets real and makes the necessary increases, this market could prove much more vulnerable than is traditional in the early stages of a rate-hike cycle ... While the growth we expect should boost earnings, through rising capacity utilization though not improved underlying margins, these gains could occur in a market that has already priced in such profits as a result of QE (quantitative easing)," he said.

"The economy will soon get even more overheated, implying a bubble and burst," he added.