Janet Yellen's daunting task as likely head of Federal Reserve

Janet Yellen, President Barack Obama’s nominee to be chairwoman of the Federal Reserve, faces the Senate banking committee this week in a confirmation hearing that is sure to ignite fireworks over monetary policy and banking regulation.

But if current economic conditions persist, all indications are that facing a handful of prickly senators and earning her expected confirmation will be the easiest part of Yellen’s tenure leading the central bank.

During the last five years, the Federal Reserve has embarked on a series of unprecedented maneuvers to stimulate the economy through the recession and a painfully languid recovery. In addition to keeping interest rates at zero, it has done three rounds of quantitative easing, an unconventional practice by which the Fed buys bonds and other assets from financial institutions in order to push more cash into the economy, keep long-term interest rates low and get people lending, borrowing and spending. The latest round, called QE3, has been in effect since September 2012 and has the Fed pumping out $85 billion a month.  

Although economists differ on how successful those policies have been in actually stimulating growth (the unemployment rate, after all, remains stubbornly stuck above 7 percent, even as stocks have rallied), they broadly agree that the program is unsustainable in the long term and must eventually be wound down as the economy picks up steam.

It will be left to Yellen — the current vice chair of the Federal Reserve and a Yale-educated macroeconomist with sterling credentials in both government and academia — to calibrate how and when to withdraw the stimulus without spooking markets, crashing the recovery or allowing inflation to rise too much. As she attempts to strike a balance between maximizing employment and maintaining stable prices — the Fed’s much-discussed “dual mandate” — 11.3 million Americans remain out of work. Millions more have stopped looking.

Outgoing Federal Reserve Chairman Ben Bernanke previously said the bank would begin to draw back from its massive bond-buying program this year and possibly raise interest rates, only to announce later that the bank would delay the “taper” until the economy showed further signs of growth. The frequent fiscal crises generated by Washington have been unhelpful on that front.

Timothy Yeager, a former economist at the Federal Reserve Bank of St. Louis and currently a professor of finance and banking at the University of Arkansas, said part of the problem is that the Fed has exhausted its capabilities.

“The Fed can’t say it out loud, but they don’t have anything left,” Yeager said.

“It’s like pushing on a string," he added, likening the lackluster economy to slack thread that needs to be tautened. "The Fed can push all it wants, but until there’s someone to pull on that string, it doesn’t move.”

The Federal Reserve’s balance sheets themselves show that there’s not much to pull on that string yet: Banks are holding onto $2.3 trillion in excess reserves — money that is not being lent out as households and businesses continue to be reticent to borrow and spend, Yeager said.

Josh Bivens, research and policy director at the left-leaning Economic Policy Institute, said that even those who were most optimistic about quantitative easing and other monetary measures to ignite economic growth have been disappointed.

“Monetary policy has got real limits when you have an economy that has as much slack as it does today,” he said. “Everyone who has hopes for unconventional monetary policy is scaling back expectations on what can be done.”

The other conundrum Yellen faces, said James Johannes, professor of finance at the University of Wisconsin’s school of business, is that the Federal Reserve is “the only game in town in terms of keeping the economy afloat.” With fiscal policy in Washington hardening around the need for spending cuts to pay down the deficit, economic stimulus isn’t going to come from anywhere else.  

“Throwing gas on a fire doesn’t make it burn any hotter,” Johannes said of Yellen’s options. “They’ve done all they can, and now the question is, how do they wind down?”  

Yellen herself acknowledged that the policies undertaken at the federal, state and local levels to pay down the debt have made the project of jump-starting growth even more difficult.

“Discretionary fiscal policy this time has actually acted to restrain the recovery,” she said in a speech given earlier this year. “State and local governments were cutting spending and, in some cases, raising taxes for much of this period to deal with revenue shortfalls. At the federal level, policymakers have reduced purchases of goods and services, allowed stimulus-related spending to decline, and have put in place further policy actions to reduce deficits.”

The good news for those hoping the Fed will be particularly cautious about upsetting a delicate recovery: Yellen has spent much of her career trying to understand unemployment and as Fed vice chair has shown a certain sensitivity to the plight of the jobless, which is part of what made her the favorite of progressive Democrats to lead the central bank.

She has been among the members of the Fed to urge it to use any and all measures that would help maximize employment, even if it meant tolerating a slightly higher rate of inflation.

“The gulf between maximum employment and the very difficult conditions workers face today helps explain the urgency behind the Federal Reserve's ongoing efforts to strengthen the recovery,” she said. “My colleagues and I are acutely aware of how much workers have lost in the past five years. In response, we have taken, and are continuing to take, forceful action to increase the pace of economic growth and job creation.”

With stints at the Federal Reserve System’s Board of Governors and the Federal Reserve Bank of San Francisco under her belt, and a turn as chairwoman of the Council of Economic Advisers during the Clinton administration, in addition to her professorship at the University of California, Berkeley, she doesn't leave the senators much to criticize about her qualifications for the job. Yellen would also be the first woman to lead the central bank.

Nobody expects a radical departure from her predecessor. Yellen has, after all, been a top deputy at the Federal Reserve under Bernanke, helping to guide the policies it has chosen so far. 

“She is the continuity candidate,” Bivens said. “I don’t see a radical break.”