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Trial by Fire

Trial by Fire

Each of the last three chairs of the U.S. Federal Reserve faced daunting challenges soon after assuming leadership of the world’s most powerful central bank. It will be no different for Janet Yellen, the highly talented and respected incoming chair. How she reacts to the set of known challenges, let alone the unanticipated ones, will impact the well-being of every American and huge swaths of the global economy.

Back in 1979, Paul Volcker came to the Fed with a mandate to snap the United States out of a debilitating period of low growth and high inflation (or "stagflation"). Shortly after taking office, he did more than raise interest rates; he embarked on a multiyear policy effort that ended up underpinning a three-decade period that took inflation from public enemy No. 1 to essentially a nonissue.

Success was far from obvious in Volcker’s early days, however, and it would not have materialized without his now-legendary steadfastness and conviction. With sky-high interest rates throwing the economy into recession, he faced enormous political pressures to abandon course, including from Jimmy Carter, the president who appointed him but then seemed surprised by the consequences of the monetary policies he pursued. Volcker made multiple brave calls along a difficult path. With the Fed-induced recession contributing to Carter’s bruising loss to Ronald Reagan in the 1980 election, you can still find Democrats today who blame Volcker for giving the election to Republicans-and for laying the groundwork for what came next.

Alan Greenspan, Volcker’s successor, faced his own moment of truth. Just months into his tenure, he had to deal with a sudden and dramatic financial market collapse. On Oct. 19, 1987 (what came to be known as Black Monday), the Dow Jones industrial average plummeted some 22 percent for no apparent reason-an unprecedented drop that threw global markets into disarray. Greenspan’s boldness in aggressively injecting emergency liquidity contained the damage and, in the process, safeguarded the integrity of the global financial system.

Fast-forward to September 2008. Just 31 months after Ben Bernanke took the reins from Greenspan, he found himself facing a fearful situation: the disorderly bankruptcy of an influential broker-dealer (Lehman Brothers), the near collapse of a massive insurance company (AIG), a potential depositor run on a large money market fund (the Reserve Fund), and a host of nightmarish cascading financial dislocations. Thrown into urgent crisis management, the new chair stepped up to battle a financial crisis that was on the verge of tipping the global economy into another Great Depression.

Bernanke was forced to do more than just come up with innovative Fed instruments to slow the metastasizing market failures that were sucking liquidity out of virtually every major economic interaction worldwide. Together with Treasury Secretary Hank Paulson, he marched up to Capitol Hill to convince skeptical lawmakers to approve a massive bailout package-with a calm, decisive persuasion of which only a scholar of his stature would have been capable.

How Janet Yellen would deal with these types of challenges no one yet knows for sure. But she had better be ready. It would not surprise me one bit if she finds herself the fourth consecutive head of the Federal Reserve to face a serious crisis soon into her tenure.

Yellen takes over a Fed that is playing an unusually broad role in supporting markets and the global economy. The institution finds itself deep in experimental mode, using largely untested tools-be it purchasing tens of billions worth of bonds a month, keeping interest rates artificially floored, or seeking to influence private-sector behavior by venturing ever deeper into "forward policy guidance" (basically, orchestrated communication to markets about the Fed’s intentions).

There are few historical parallels, analytical models, and policy playbooks to guide her. Indeed, there isn’t even a common and detailed understanding among academics of how the Fed has really influenced economic prospects and the functioning of markets since the global financial crisis. Meanwhile, financial investors are delighted to have the continuous support of the Fed’s wide-open wallet, which has driven asset prices to rise to historical records, despite unusually sluggish fundamentals.

It’s not quite a poisoned chalice, but Yellen is taking over a Federal Reserve that has ended up, mostly inadvertently, underwriting a series of consequential and unusual disconnects. Under her guidance, the Fed will need to find a way to better reconcile booming financial asset prices with the unfortunate realities of what is now being labeled "secular stagnation"-an unusually prolonged period of low growth and high unemployment. The central bank will also have to find a way to reconcile its steadfast commitment to supporting the domestic economy with the disruption that causes for other countries. After all, with the United States both supplying the global reserve currency and hosting the world’s deepest financial markets, what the Fed does has enormous consequences for the flow of international capital in and out of other countries. Those countries have felt the Fed’s largesse, and many will find their capacity to cope challenged when the taps begin to close.

Yet the Fed under Yellen will need to find a way to transition the economy from artificial growth to genuine private-sector-led growth. It must gradually reduce its direct involvement in the markets and do so without causing disorder that undermines economic growth. Bernanke has already signaled the route ahead: namely, a gradual retreat from monthly bond purchases in favor of great reliance on forward policy guidance.

There may be no imminent crises like the ones Volcker, Greenspan, and Bernanke faced. Yet the situation Yellen inherits is arguably more complicated and fluid. Indeed, it may well constitute one of the most complex challenges ever faced by a central bank. If that weren’t enough, the Fed’s tool kit is ill-equipped for the task at hand, and the institution is hampered by political polarization and congressional dysfunction.

No one knows for sure how much time the Fed has before it must deal with the unintended consequences of its experimental policies. It could be months; it could be years. Much depends on whether Bernanke has actually bought enough time for U.S. household balance sheets to heal and for the economy to pick back up robustly.

But Yellen can’t wait to find out. She needs to deliver on four interrelated fronts early on in her tenure. First, as the benefits of the Fed’s unconventional stimulus decline, as they inevitably will, she must avoid exposing the fragility of a recovery still hampered by inadequate infrastructure and demand, unresolved pockets of excessive indebtedness, and long-term unemployment.

Second, with many equities and corporate bonds flirting with bubble-ish levels, she must work with other agencies to ensure that recent progress in banking regulation and supervision has materially reduced the threat of destabilizing market incidents.

Third, she must find a way of breaking the unhealthy co-dependency that has developed between markets and the Fed. Markets cannot function well in the long term on the assumption that they will always have the Fed to support them, and the Fed cannot always rely on artificially boosting financial assets to promote growth and jobs.

And fourth, she must clearly communicate Fed policy in a world that has become extremely sensitive to every word, signal, and whisper emanating from the world’s most powerful financial institution.

What is undeniable, even at this early stage, is that the to-do list awaiting Janet Yellen when she enters the Fed is as daunting as those that ended up facing her three predecessors. And we have no idea what challenges and crises the world could soon throw her way. She brings enormous talent and experience to the Fed chair, but she’ll need some good luck too.