Policy challenges loom as Yellen prepares to lead Fed

(REUTERS) - Ms Janet Yellen, who was confirmed by the United States (US) Senate on Monday to succeed Mr Ben Bernanke as chair of the Federal Reserve, will take the helm of the world's most influential central bank as it attempts to finally move on from an era of economic crisis.

When Ms Yellen, an accomplished economist and the Fed's current vice-chair, takes the reins on Feb 1 she will face a series of delicate policy challenges, starting with how quickly to wind down the Fed's aggressive bond-buying campaign.

Here are the main challenges on the horizon:

BLOATED BALANCE SHEET. After three rounds of quantitative easing, or QE, the Fed's balance sheet has swelled to about US$4 trillion (S$5 trillion), a record level and far higher than the approximately US$1 trillion the Fed has carried in more normal times.

Some fear the money the Fed created to purchase this haul of Treasuries and mortgage-backed securities with the aim of encouraging investment, hiring and economic growth could stoke inflation in the years ahead, and potentially cause hard-to-detect market disruptions and asset bubbles.

The Fed announced on Dec 18 that it would modestly trim the pace of its monthly bond purchases to US$75 billion in January from US$85 billion. But it remains keen to keep borrowing costs low by convincing investors that interest rates will not rise for a while longer.

The trick for Ms Yellen will be winding down QE without rattling financial markets or disrupting an economic recovery that has proven vulnerable to domestic and foreign shocks.

LIFT-OFF FOR INTEREST RATES. The Fed's main policy tool, the overnight federal funds rate, has been near zero since the darkest days of the financial crisis in late 2008. The first increase is not likely to come until 2015, based on Fed predictions, though that could change if inflation or unemployment veer away from expectations.

The central bank had said it would keep rates where they are at least until unemployment dropped to 6.5 per cent, as long as inflation did not threaten to top 2.5 per cent.

It tweaked that pledge on Dec 18, saying it likely would be appropriate to keep rates near zero "well past the time" that the jobless rate fell below 6.5 per cent, especially if inflation expectations remained below target. The jobless rate stood at 7.0 per cent in November.

But financial markets at times have questioned the credibility of the Fed's policy promises. If investors start to expect rates will rise earlier than the Fed intends, borrowing costs could start to rise and trip up the economy.

Some officials want to lower the jobless rate threshold to underscore the Fed's commitment to keep borrowing costs low.

Ms Yellen will now have to take the lead role in guiding expectations.

UNEMPLOYMENT, INFLATION (AND DISINFLATION). Right now, everyone agrees that unemployment is too high and inflation too low, so the Fed has faced a relatively easy decision on keeping monetary policy very loose.

But inflation is running well below target. If it does not start to pick up, policymakers will face the difficult question of whether to ramp up their already extraordinary stimulus to stave off deflation.

On the other hand, if inflation perks up and threatens to reach the Fed's 2.5 per cent upper threshold, policymakers might be forced to tighten policy despite higher-than-desired joblessness.

Possibly complicating things, the Fed will for the first time be able to also raise the interest rate it pays banks on the excess reserves they hold at the central bank. Doing so should stem what could otherwise be a flood of bank reserves into the marketplace that could threaten to overheat the economy - but it is an untested tool.

LONGER-TERM EXIT STRATEGY. Further out on the horizon, the central bank will have to shrink its balance sheet to a more normal size, whether by letting the bonds it holds mature or selling them outright. The quicker it reduces holdings, the tighter monetary policy will become and the greater the pressure on markets to absorb the assets.

But perhaps most sensitive for the Fed, selling bonds could give rise to losses that would lead to a temporary end to its regular remittances to the US Treasury, potentially opening the door to action by politicians who want to rein in the central bank's prized independence.

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