Grading the Federal Reserve's Laboratory

A clinical laboratory is a place where tests are conducted on specimens to gather information about the diagnosis, the treatment and prevention of disease. The general idea is to help patients to get healthy and stay healthy. It's also a good analogy for monetary policy, so let's grade the Federal Reserve's financial laboratory.

The Fed's Laboratory

The Fed's laboratory is a place filled with mostly academic types and ex-Wall Street people who speak the language of double-talk. Just comb through any Fed statement and you'll get the drift. One whole sentence thoroughly contradicts the next and the next until everything becomes as clear as mud. I've never been a Fed-watcher myself, but credit goes to anyone intrigued by the Fed's tangled morass. It's confusing work.

As any qualified laboratory scientist will explain, lab safety is always a priority. And the Federal Reserve, lamentably, hasn't done a good job in this department.

Before the onset of the recession, the Fed held between $700-800 billion in U.S. Treasuries on its balance sheet. In late 2008, it started buying $600 billion in mortgage-backed securities. By the spring of 2009, it held approximately $1.75 trillion in bank debt (NYSEArca: KBE), MBS (NYSEArca: MBB) and Treasuries. As of June 1, 2011 the Fed's balance sheet ballooned to $2.79 trillion with just $52.6 billion in capital. That's a 53-to-1 leverage ratio according to your calculator and it's also a ratio that easily exceeds Bear Stearns and Lehman Brothers just before their failure.

In other words, the Fed's monetary lab work has weakened itself and its further ability to be a potent force. The Fed's laboratory gets an 'F' for safety violations.

Experimental Effects

After injecting an experimental drug into a specimen, a scientist must wait for its reaction. If the reaction is poor, the scientist should not repeat the same procedure or something similar hoping for a better result, but move on to something else.

In this regard, the Fed began its first round of experimenting (QE1) with a multi-billion dollar buying spree of toxic assets. It subsequently followed that up with a second round of experimenting (QE2) - this time buying U.S. Treasuries. How did the specimen react?

The price of stocks (NYSEArca: IWB) and government bonds (NYSEArca: TLT) responded by rising. And so did riskier assets like junk bonds (NYSEArca: JNK) and highly leveraged real estate investment trusts REITs (NYSEArca: VNQ) and mortgage REITs (NYSEArca: REM). Although each of these areas responded favorably to the Fed's experimenting, the treatment ultimately failed to reach its intended patient - the broader economy.

In terms of observing its own experimental effects and results, hereto the Fed's laboratory fails.

Your Post-QE2 Questions Answered

We've just graded the Federal Reserve's laboratory in two key areas and we're still not done. A laboratory should be a controlled environment with strict safety rules. But as you've just witnessed, the Fed's lab is the sort of place that makes Victor Frankenstein's workplace look like a Sunday stroll through the park.

The Federal Reserve has violated important rules. Lab experimenting should never put the scientist's own health at risk. Likewise, the scientist should always remain fully aware about the test results on his patient. If the test results are undesirable or ineffective, the scientist should not deny them.

Now thatthe Federal Reserve's massive intervention into the financial markets (QE2) is nearly over, what will it mean for stocks and bonds? Which ETFs and asset classes will be the winners and losers? ETFguide's next Webinar titled 'What's Your Post QE2 Strategy?' will closely analyze this.

In upcoming articles, we'll be grading other aspects of the Federal Reserve's laboratory. Stay tuned!

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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