NEW YORK (TheStreet) -- At a Senate confirmation hearing Thursday, Janet Yellen, the nominee to chair the Federal Reserve, plans to deliver a bearish assessment of the U.S. economy.
Wall Street is delivering a mildly bullish reaction, however, as traders interpret Yellen's remarks as an indication the central bank will continue its policy of quantitative easing. The Dow Jones Industrial Average was up 30 points, or 0.2%, at midmorning Thursday, while the S&P 500 was up nearly 6 points, or 0.3%.
In her prepared remarks, Yellen said that although progress has been made in the recovery from the Great Recession, the American job market and economy were still "performing far short of their potential."
Yellen said, "We have made good progress, but we have farther to go to regain the ground lost in the crisis and the recession. I believe that supporting the recovery today is the surest path to returning to a more normal approach to monetary policy."
Under Quantitative Easing III, announced in September 2012, the Fed purchases about $1 trillion annually of Treasuries and mortgage-backed securities that other investors won't buy at the prevailing interest rates.
Quantitative Easing III is needed as there is not enough demand from the market for Treasury debt with such a low yield. If there were, there would be no reason for the Federal Reserve or any central bank to embark on quantitative-easing programs.
The Federal Reserve's balance sheet has ballooned from around $700 billion in 2007 to about $4 trillion.
In an interview with The Wall Street Journal, George Schultz, who has served as Secretary of State and Treasury Secretary, warned, "It's startling that in the last year, three-quarters of the debt that's been issued has been bought by the Fed, and the balance has been bought by other countries, so U.S. citizens and institutions are not on net buying U.S. debt ... The Fed doesn't have an unlimited capacity because when it buys the debt what it's doing is monetizing the debt. Sooner or later that has to get out into the economy."
Richard Fisher, the president of the Dallas Federal Reserve issued a warning of his own in a recent speech: "The balance sheet is $4 trillion and there are limits to what the Federal Reserve can do."
The policy has been bullish for the stock market, however. By keeping interest rates low, quantitative easing makes equities more attractive than bonds. This is especially true for stocks that have a healthy dividend yield. The policy also makes it easier to borrow money to buy equities. Low interest rates also strengthen the financial industry, which is critical for the economy and for the stock market to rise.
As a result, the financial services sector should continue to do well.
Despite record legal expenses and fines that resulted in a loss in the most recent quarter, shares of JPMorgan Chase (JPM) are up more than 27% this year. Shares of Bank of America (BAC) have risen more than 27%, and Well Fargo's (WFC) stock is up more than 28%. Shares of Goldman Sachs (GS) have surged almost 30%.
What is bullish for the economy is that inflation continues to be low. According to Yellen, it's expected to remain so for some time. The low inflation rate is helping to protect the dollar from the devaluation that would be expected from the quantitative easing measures that have produced trillions of new greenbacks without the corresponding economic growth.
For investors, the liquidity-driven rally in the stock market should continue despite adverse economic indicators such as rising unemployment and bankruptcies of major cities.
JPMorgan Chase, Goldman Sachs, Wells Fargo, Bank of America and others in the financial sector can be expected to continue rising.
But something has to be done about the size of the Federal Reserve balance sheet. Common sense dictates that if expanding it by trillions lower interest rates, than contracting it by trillions will increase interest rates. When that happens, the reaction from the stock market will not be bullish.
Jonathan Yates does not have a position on any of the stocks mentioned in this article.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.