Yellen's long journey: a transition fraught with risks.

• Author: Berry, John M.

In terms of intellect, training, personality, and experience, Janet L. Yellen was as qualified as anyone in history to be chair of the Federal Reserve when she was sworn in on February 1. She was already the central bank's vice chair and earlier had been a member of the Fed Board and president of the San Francisco Federal Reserve Bank. But none of that means she's going to have an easy first year on the job.

Fed policy has entered a period of transition with the Federal Open Market Committee taking the first step to slow the increasing flow of massive liquidity to the economy. That's also the beginning of the long journey to "normalize" policy--that is, return eventually to focusing on moving overnight interest rates up and down to stabilize the economy. The transition is fraught with risks for Yellen and the Fed.

Fortunately, she likely will soon have the help of Stanley Fischer, one of the most respected economists and central bankers in the world. Fischer, who ably led the Central Bank of Israel through the crisis, has been nominated by President Obama to replace Yellen as Fed vice chairman. Lael Brainard, another mainstream economist with public policy experience, most recently as undersecretary of Treasury for international affairs, has also been nominated to join the Fed Board. Both are expected to be solid Yellen allies.

There is strong opposition among conservatives to many of the things the central bank has done to deal with the financial crisis and its aftermath, and there is a nascent effort to curb its powers in the future. How successful that attempt will be is hard to predict, but some actions the Fed will have to take as part of the policy transition, such as increasing the interest rate paid on bank reserves, won't be politically popular.

Many of the underlying problems Yellen faces have their roots in misguided fiscal policy. Following the financial crisis, small-government conservatives in Congress, occasionally with the help of the Obama administration, cut government spending enough to partially throttle the economic recovery. Given the drag from fiscal policy, reducing the Fed's target for overnight interest rates from 5.25 percent almost to zero in 2008 was not enough to spur growth and quickly bring down the high unemployment created by the recession. Most Fed officials, including Chairman Ben S. Bernanke, were not willing to shrug and say there's nothing more we can do.

Unable to lower short-term rates any further, the Fed sought to bring down longer-term rates as well. Since long rates are affected by

expectations of changes in short rates, officials promised not to begin to raise them until well into the future. In addition, officials began to swap some of the tens of billions of dollars worth of short-term Treasury securities in their portfolio for longer-dated ones. Then they began to buy large quantities of both longer-term Treasuries and mortgage-backed securities. Finally, their "forward guidance" about when and under what circumstances they might begin to raise short-term rates became ever more explicit.

By the fall of 2012, each month the Fed was purchasing $40 billion worth of mortgage-backed securities and $45 billion worth of long-term Treasuries as part of its so-called quantitative easing policy. Some FOMC members opposed quantitative easing from the beginning and questioned its efficacy. Others were disturbed by its open-ended nature.

In December, the FOMC began pulling back. It reduced the quantitative easing purchases in January to $75 billion a month from $85 billion and lowered that again to $65 billion in February. In Yellen's first congressional testimony ten days after becoming chair, she said this tapering of purchases would continue unless the economic outlook becomes much weaker than Fed officials now expect.

The purchases over several years have expanded the Fed's balance sheet to more than $4 trillion, and if they end later this year the total will be close to $4.5 trillion. That is a serious complication as far as normalizing policy is concerned. In the past, the Fed kept overnight rates approximately where officials wanted them by adding or subtracting bank reserves--cash really--available in the banking system. However, currently about $2.5 trillion worth of the liquidity the...