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New Fed chief, whoever it may be, faces a trial by fire

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Former Treasury Secretary Larry Summers should be at least a little relieved he's not getting the job.

Sunday's surprise announcement that he was out of the running as the next Federal Reserve chairman stunned Washington and Wall Street after an unprecedented round of press speculation and behind-the-scenes lobbying. The move leaves Janet Yellen—current vice chair and former White House economist in the Clinton administration—as the likely, but far from certain, nominee.

Whoever is tapped to take the helm of the world's largest and most powerful central bank, whether it's Yellen or someone else, will have to sail the Fed into uncharted, and increasingly perilous, waters five years after the global economy was torpedoed by the bursting of a reckless credit bubble.

After bloating its balance sheet with more than $3 trillion in bonds to suppress interest rates to near zero, the central bank's efforts so far have produced one of the weakest economic recoveries in its 100-year history.

"The economy without debt is like Major League Baseball without steroids." -Jack Ablin, Chief investment officer at BMO Private Bank.

"Every year, you start out with economists thinking it will be a 3 percent growth year," said Tom Porcelli, chief U.S. economist at RBC Capital Markets. "And of course, that never materializes. So I think, unfortunately, we remain stuck in the 2 percent growth backdrop."

That backdrop has left millions of American workers without a paycheck, has held back consumer spending, the main driver of economic growth, and mired 15 percent of the nation in poverty.

The new Fed chairman's job will be to continue to try to fulfill the central bank's two, often conflicting, mandates: fighting inflation and boosting employment. And she (or he) will have to do it with little help from Washington, which continues to bicker over spending.

For now, the first mandate has been a success. But it's not clear how much credit Chairman Ben Bernanke and his colleagues can take for that. Prices have been tame largely because a weak economy has produced lackluster demand for goods and services, and a lousy job market has kept wages from rising.

(Read more: Looking for a raise? Good luck with that)

The central bank's efforts to spur job growth have been far less successful. While the official unemployment rate has fallen from a recession peak of 10 percent to 7.3 percent in August, the improvement has come almost entirely because so many jobless workers have left the work force. If those "missing" workers were accounted for as part of the official labor force, the jobless rate as of last month would have been 11.2 percent.

To be sure, many of those "missing" workers are baby boomers who have begun retiring in large numbers. But their departure from the work force has the same dampening effect on the economy; they are no longer producing goods and services and they consume less as they begin living on savings and fixed incomes such as pensions or Social Security checks.

After five years of stimulus, the lack of progress on job growth now badly complicates the Fed's job.

The central bank's biggest single response to the financial collapse and recession was an unprecedented program of siphoning some $3 trillion in Treasury debt and mortgage-backed bonds to suppress interest rates. Never in its 100-year history has the central bank pumped so much cash into the system, leaving it with a mountainous debt pile on its books—more than five times precrash levels.

(Read more: Home prices across the US defy gravity, despite rising rates)

No one is even talking about how to unwind that debt pile. The question that has consumed the global financial markets since Bernanke in June first hinted of a policy shift: When will the Fed start slowing its debt buying spree? Just the mention of a "tapering" policy sent mortgage interest rates spiking by more than a full percent in May and June, as investors bet that a rise in rates was coming.

The timing of that looming tapering is critical. If rates rise too fast, too soon, the recent housing recovery could quickly stall, sending an already weak economy back into recession. But continuing the Fed's massive purchases of bond buying—an experimental idea with unknown long-term consequences—carries an entirely different set of risks.

"The reason why you're going to see the taper is not because the (Fed) has declared victory on the economy. They haven't," said Mohamed El-Erian, CEO of Pimco, a big bond fund. "It's because they're worried about what Mr. Bernanke has called the cost and risks, the collateral damage, if you like, of using such a blunt instrument to impact markets. You cannot repress interest rates forever in a modern market without causing damage, and I think the Fed realizes that."

That damage includes the potential risk of fueling another bubble like the one that led to the 2008 crash in the first place. For now, the recent rise in the prices of both houses and stocks seems to be justified based on long-term increases in value. But Fed officials have acknowledged that bubbles are very hard to see coming.

(Read more: Economists' latest forecast: Better, but not great)

Ultra-low rates have also punished savers and retirees living on fixed incomes, forcing them to tighten their belts or take on greater risk in the stock market, putting their nest eggs at greater risk.

The Fed's easy-money policy, meanwhile, has done little to spur more borrowing, leaving the central bank as the economy's borrower of last resort.

Much of the growth in the last expansion cycle was fueled by borrowing—too much, it turns out. But with consumers and businesses unwilling or unable to borrow more, that source of growth has been missing from the current recovery. If the Fed tapers its bond buying and lets rates rise, households and businesses will be even more reluctant to borrow.

"The economy without debt is like Major League Baseball without steroids," said Jack Ablin, chief investment officer at BMO Private Bank. "The fact is 2 percent is probably the natural rate of growth, unfortunately. For the last 30 years or so, consumers have supplemented their income with debt, and they're obviously busy paying off their debt this time around."

As if the new Fed chairman's job wasn't tough enough, the central bank has been hampered by fiscal policy as Congress tries to balance the federal budget. Those efforts brought a round of tax increases earlier this year that have dampened consumer spending, along with big "sequester" spending cuts that have taken another bite out of gross domestic product.

That is exactly the reverse of past economic stimulus policies that used tax cuts and increased spending to spur growth. With another contentious battle looming over raising the government's borrowing limit, the drag from congressional spending cuts shows no signs of easing.

—By CNBC's John W. Schoen. Follow him on Twitter @johnwschoen.

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