Wagging the Dog: Why the Fed Fears Wall Street

Ben Bernanke, chairman of the Federal Reserve.
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Ben Bernanke, chairman of the Federal Reserve.

The stock market has long been the mistress in the marriage between the Federal Reserve and the economy.

While central bank policy is supposed to be focused solely on maintaining full employment and price stability, boosting the equity market has been a furtive goal of monetary policy—generally not part of Open Market Committee discussions but never far from mind.

That surreptitious relationship came further into the open at the April 30-May 1 meeting, when Fed members discussed Wall Street expectations for the historically high level of central bank easing.

"A few members expressed concerns that investor expectations of the cumulative size of the asset purchase program appeared to have increased somewhat," the meeting minutes stated, noting further that those expectations have come even though the unemployment has dropped.

(Read More: The Market Is Not the Economy: What the Fed Doesn't Get)

Indeed, the jobless rate has fallen to 7.5 percent, but that hasn't been enough to assuage investors.

"The weakness in global equity markets since the release of the FOMC minutes on Wednesday backs our view that the rally had become overly dependent on expectations of further support from monetary policy," Julian Jessop, chief global economist at Capital Economics, said in an analysis.

The mere mention from Chairman Ben Bernanke, in Congressional remarks Wednesday, that the Fed was contemplating an early exit from its monthly asset purchases sent global market into a tizzy, though the U.S. seemed to recover its bearings Thursday.

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"The market's just gotten used to it," said Quincy Krosby, chief market strategist at Prudential Annuities. "The notion of liquidity is in and of itself the trigger for money to flow into riskier assets. When you talk about or mention the mere notion that this may be pulled back, it upsets markets."

Under more typical circumstances, markets would recoil from the weak top-line revenue growth that companies showed in the first quarter.

Instead, the only thing that has gotten in the way of the 2013 rally has been fear over a Fed retreat.

"What the market typically does when top line revenue growth gets pulled down, it sells off in order to assess the environment, in order to recalculate, to get more information," Krosby said. "This market, because of the Fed, is not worried about fundamentals, does not care about fundamentals."

While the extent to which the Fed itself is influenced by market reaction is difficult to gauge, the markets certainly thinks it holds sway.

(Read More: Does Asia Slump Signal US Bump or Correction?)

Most analyst or economist commentary about the impact of a Fed pullback focuses far more on the impact for the financial markets than it does unemployment, interest rates or the broader economy.

Speculating on how the central bank might ease its $85 billion a month in purchases of Treasurys and mortgage-backed securities becomes a calculation of how the Fed can do so with the least disruption to Wall Street.

"We think that the FOMC is still more likely to wait until its mid-September meeting" to start cutting back, Paul Ashworth, chief US economist at Capital Economics, said in a report.

Importantly, Ashworth pointed out that "even if the Fed opted to start slowing the pace of purchases as soon as next month, it could begin with a relatively trivial reduction to gauge market reaction."

Of course, markets also encompass the debt trade as well, and keeping interest rates row as the economic recovery slogs along is important.

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The equity markets and bond yields have been moving in reverse, an important calculus for the Fed to maintain no matter how much lip service it gives to inflation and unemployment.

"Market reaction during Bernanke's testimony highlights the challenges the Fed faces in communicating its intentions," Michael Hanson and Ethan Harris, economists at Bank of America Merrill Lynch, said in a note.

What drives the Fed dynamic is multi-faceted: On one hand there's the simple desire among stock investors for liquidity that drives the trade, and on the other the belief that the Fed's policies have done more than that in improving economic fundamentals though the job is not complete.

"A big thematic in this business is with the Fed," said John Stoltzfus, chief market strategist at Oppenheimer. Referring to the market rally, he said, "If we didn't have Bernanke, I don't know if we'd be talking about this."

_By CNBC's Jeff Cox. Follow him on Twitter at JeffCoxCNBCcom.