Janet Yellen's Fed: Challenges Start Immediately

Friday jobs report could cause a Fed policy shift, and that's just the start of Janet Yellen's to-do list.

Janet Yellen is sworn in as Federal Reserve Board Chair, in Washington, Monday, Feb. 3, 2014.

New Federal Reserve Chair Janet Yellen will be tasked with unloading the agency's $4 trillion collection of assets.

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Sometimes you start a new job and don’t even have time to settle into your new office before the workload gets overwhelming. That may be what Federal Reserve Chair Janet Yellen felt like Monday when she took over as head of the central bank.

One of her earliest stressors could come Friday, when the jobs report comes out. This is the purview of the Labor Department, but the central bank will be watching it closely. The Fed has tied its interest rate policy to the unemployment rate, saying it expects to keep the federal funds rate near zero “at least as long” as the jobless rate is above 6.5 percent. The unemployment rate is currently 6.7 percent, having fallen by 1.2 points since the Fed first issued this guidance in December 2012, but not entirely because the job market is healthy.

[READ: Federal Reserve Continues Taper, Cuts Monthly Purchases to $6.5 Billion]

“The key question is what will happen to labor force participation," says Randall Kroszner, a former Federal Reserve governor and a professor of economics at the University of Chicago’s Booth School of Business. "Labor force participation has been falling like a stone, and that is what has been driving down the unemployment rate."

The jobless rate may not fall to 6.5 percent in the next jobs report -- consensus expectations are for it to hold steady at 6.7 percent -- but the unemployment report has been known to surprise, and inching any closer to that 6.5 percent threshold might mean talking more about what could prompt higher interest rates. This means Yellen’s first big test will be communication, an area in which her predecessor, Ben Bernanke, changed the Fed dramatically.

“That's going to be a key challenge to be able to communicate to the markets what criteria they’re going to be using,” says Kroszner. This will involve both choosing and explaining a new tack, as simply picking a new unemployment rate threshold might not work.

“When you start moving the goalposts, people take less seriously what those goals are,” says Kroszner.

Beyond short-term policy decisions, Yellen will face the most daunting challenge of all: the Fed’s $4 trillion balance sheet. Yellen’s task involves unwinding that unprecedentedly large collection of assets, brought on by years of unprecedented quantitative easing policies put in place to prop up the U.S. stalled economy following the recent recession. This policy is sometimes referred to as "printing money."

At the very least, Yellen may get to rest easy on major tapering decisions as the central bank dials back its monthly asset purchases, known as QE3, says one expert. That policy, so titled because it is the third round of quantitative easing, initially consisted of $85 billion in monthly purchases of mortgage backed securities and Treasurys. In each of the last two meetings, the Fed’s Open Market Committee has pulled that total back by $10 billion, a gradual taper that is expected to continue.

"The Fed has already established a glide path at its December FOMC meeting; Yellen doesn't have to make a lot of immediate big decisions. She can focus on building a framework for monetary policy," says Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.

[ALSO: Loose Policy and Loose Lips Define Bernanke's Legacy]

But the Fed is still providing stimulus, albeit more slowly. When it comes time to go in reverse and get rid of those assets, it will be a challenge new to U.S. central bankers.

One option is to simply let the treasuries on the Fed’s balance sheet to mature and slowly fall off. Likewise, as people sell homes and pay down their mortgages, the value of mortgage-backed securities on the balance sheet will shrink, says Stephen Oliner, a resident scholar at the American Enterprise Institute and a 25-year Fed veteran.

“That's their default plan. I think it makes sense in terms of what they should be thinking they'll probably do,” says Oliner.

Not that that’s a fail-safe plan. The Fed may be better off selling its assets more quickly, says LeBas.

"I think the bigger risk is that the federal reserve fails to unwind their accommodation fast enough. And what that would likely look like is asset bubbles,” he says. He points to the recent housing crisis as an example of an asset bubble that popped, to disastrous effect.

“That’s the biggest risk is that the Fed’s too slow in pulling the punch bowl away,” LeBas says.

Yellen will manage all of this while walking the Fed’s usual dual mandate tightrope: promoting full employment while keeping inflation in check. At the start of quantitative easing, many worried that inflation would spike. That hasn’t happened -- at the end of last month, inflation was at only 1.1 percent -- and one reason why the fed’s money-printing hasn’t stimulated price spikes is that the money hasn’t reached consumers’ hands, says LeBas.

"The transmission mechanisms...are so broken is that there's very little risk of substantial inflation," he says. "That's not because banks are somehow failing us as consumers but because consumers have no demand for borrowing."

Still, for some the fear remains. Philadelphia Fed President Charles Plosser voiced these concerns to CNBC in November.

“We have created over $2 trillion of excess reserves that are sitting on the balance sheets of the banks, it’s just sitting there, it’s not inflationary,” he said. “It will be inflationary when that starts to flow out of the banking system, that’s when we’ll have to start worrying about inflation.”

[DEBATE CLUB: Should the Federal Reserve Keep Interest Rates Low?]

The Fed cannot take its eye off of the possibility of inflation, but at a time of such slow price growth, it also must keep watch for deflation. While shrinking prices might sound great to consumers, it can have disastrous economic effects, causing pullbacks in spending and borrowing, and ultimately creating an economic slowdown.

“Low inflation rates broadly are good, but when they get too low and there’s a negative shock to the economy you can get into a very difficult deflationary scenario,” says Kroszner. The fact that Yellen will have to maintain a close watch on both possibilities, he adds, is one factor that will make the next few years all the more challenging.

“In the old days the main devil was inflation. But now you have the devil of deflation still there,” he says. “It's a difficult balancing act. Being a central banker in this period is a particular challenge.”