The last three Federal Reserve chairmen faced significant defining challenges early in their tenures. Janet Yellen, President Obama's choice to succeed current chairman Ben Bernanke, can expect the same.
First, let's recall what her predecessors faced.
Paul Volcker was appointed by Jimmy Carter in August 1979, when oil prices were rising sharply and inflation had hit double digits. Volcker's defining decision was to attack inflation hard in order to restore the Fed's credibility as an inflation fighter, which Volcker felt had been lost under Arthur Burns.
Volcker purged inflation, but at the cost of a short, sharp recession in 1980 and a much deeper one in 1981-82, with unemployment peaking at 10.8 percent. The Fed has enjoyed credibility on inflation ever since, leaving the question of whether the economy had to be hit so hard to achieve it.
Alan Greenspan succeeded Volcker in August 1987 and the stock market crashed shortly thereafter. The S&P 500 lost a fifth of its value on October 19, and the normal credit channels that facilitate financial transactions ("liquidity") began to dry up. Greenspan responded quickly, first reassuring markets that the Fed stood ready to support the economic and financial system. Greenspan's Fed then fulfilled its "lender of last resort" responsibilities and greatly expanded the money supply, recognizing that, as a temporary liquidity measure, it would not be inflationary.
Greenspan's decisive actions prevented a financial panic from morphing into a recession, but they were not designed to address systemic problems in the financial system that helped fuel the crash in the first place. Those problems receded from view in the 1990s as the nation enjoyed its longest peacetime economic expansion, from 1991 to 2001.
Macroeconomic and budget policy seemed to work well together in that expansion. President Clinton and a Republican Congress operated within a budget framework that produced surpluses by the end of the decade. Greenspan presciently recognized that monetary policy could allow the unemployment rate to fall lower than experts had thought without triggering inflation.
Bob Woodward's "Maestro," celebrating Greenspan's achievements, was published in 2000 – before Greenspan's implicit endorsement of the Bush tax cuts in 2001, before the subsequent re-emergence of budget deficits and before the consequences of inaction on the kinds of system-wide risk that generate financial crises became glaringly evident in 2008.
Ben Bernanke succeeded Greenspan in 2006 and enjoyed a relatively quiet first two years. Then came the 2008 financial crisis and Great Recession. The financial crisis dwarfed anything during Greenspan's tenure, and the Bernanke Fed took extraordinary steps to address the fallout, including, most notably, pushing short-term interest rates effectively to zero and purchasing large quantities of longer-term financial assets in an effort to lower longer-term interest rates and encourage economic activity (the policy known as quantitative easing or QE).
Janet Yellen will inherit legacies from all three of her predecessors if, as expected, she's confirmed. But she will also inherit a dysfunctional political environment that will complicate her job.
The Fed has a dual mandate from Congress to pursue high employment and stable prices. As I have said, the Fed has enjoyed credibility as an inflation fighter since Volcker but Yellen, like Bernanke, understands that jobs are still the top priority for monetary policy. Many Congressional Republicans, however, want to replace the Fed's dual mandate with a single mandate for long-term price stability (and some even want to see a return to the gold standard).
The Fed has indicated that it wants to begin scaling back its asset purchases and eventually unwind its holdings, but not at the expense of the economic recovery and not until employment is clearly returning to normal levels. If not reversed, our current political breakdown, which has shut down parts of the government and risks a major economic and financial crisis over the debt ceiling, will put an increasing burden on the Fed at a time when its toolshed is growing bare.
Finally, policymakers have not adequately addressed the problems with the financial system, as first revealed in the 1987 crash and more acutely in the 2008 panic. While the Fed has a role to play in that endeavor, it can't singlehandedly solve the problem.
Janet Yellen has the talent and experience to be a great Fed chair. But she will need some help from a functioning political system.