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Senate approves Janet Yellen as Fed chair

Janet Yellen
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The Senate on Monday approved Janet Yellen to become the next chair of the Federal Reserve. She currently serves as Fed vice chair and previously worked as head of the San Francisco Fed.

The recent string of positive economic news could turn into a headache for Yellen as she takes the reins at the Federal Reserve.

Despite misgivings over current Fed direction, Yellen seemed a sure choice to succeed current Chairman Ben Bernanke, who began his term in 2006.

She faces an immediate challenge that will test her communication and policy skills.

With gross domestic product growth above 4 percent and the stock market roaring along—save for Thursday's year-opening sell-off—the new central bank chief could have a harder time justifying the Fed's crisis-era monetary policy.

"With growth (in 2014) to the mid-3s and potentially higher, you're actually adding accommodation to the economy," said Joe LaVorgna, chief U.S. economist at Deutsche Bank. "Yes, you're slowing the pace of the buying, but the balance sheet is still growing. It's staggering to me. I just don't see how they're going to get out in a clean way."

The Fed indeed does intend to ease the pace of its monthly asset purchase program—quantitative easing—from $85 billion to $75 billion, but the balance sheet will continue to grow, after ending 2013 at just more than $4 trillion.

Simultaneously, the Fed is holding its target funds rate near zero, a level it has maintained since the onset of the financial crisis in late 2008.

As Yellen gets ready to succeed outgoing Chairman Ben Bernanke when his term expires Jan. 31, coming up with a viable communication strategy is likely to be at the top of her priority list.

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"Either there's going to be a major accident on the path to normalization and/or there's going to be a financial asset bubble or inflation somewhere down the line," LaVorgna said. "Something has to break. We haven't felt the full effects of the accommodation."

In the financial markets, adjustment to the new Fed tapering path has been fairly uneventful.

Stocks closed the year with gusto, sending the up some 29 percent and other indexes, such as the small-cap barometer, up even more.

Among other things, QE's effects also have begun to show up in monetary aggregates, with the flow of cash—a key indicator of inflation—accelerating late in the year.

M-2, which measures time deposits as well as cash and checking deposits covered in M-1, surged 7.7 percent in the fourth quarter and 6.3 percent year over year. M-1 jumped 11 percent in the fourth quarter and 8.6 percent annualized.

Investors, then, are understandably cautious about Fed ramifications despite the otherwise sanguine market signs.

(Read more: Prediction for 2014: First the taper, then the un-taper)

"Everybody likes the good-performing markets. When the markets are performing on the back of something that's manufactured and not real, we worry," said Rob Lutts, chief investment officer at Cabot Money Management in Salem, Mass. "The cost of capital is clearly a lot higher than what the marketplace is pricing in today. This is problematic. It means that investors are maybe doing things that they shouldn't be doing."

Misallocation of capital is always a concern during times of extreme Fed accommodation, and this time likely will prove to be no different.

For instance, margin debt on the New York Stock Exchange surged to $423.7 billion as of November, a 16 percent increase through the year and easily a record high.

For Yellen, that will mean some hard work.

In that vein, some on Wall Street believe the leadership transition already has begun.

"In essence, Janet Yellen has been at the shadow helm since last September," said Quincy Krosby, chief market strategist at Prudential Annuities. "She's been a very behind-the-scenes voice for her position at the Fed. When it became clear that she was the candidate after Larry Summers (withdrew from consideration), her hand was without a doubt on policy."

The final months of 2013 marked a Fed transition period, with the Open Markets Committee voting for a tapering ahead of the schedule that the market had anticipated.

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As that has transpired, it has raised questions over whether the rate tightening schedule may get accelerated as well. If so, it would conflict with a major priority of Yellen's, namely the forward guidance on rates that she believes can be used to direct future expectations of the financial markets.

That adherence to forward guidance also puts her at loggerheads with her likely vice chairman, Stanley Fischer. who has criticized it as an effective tool and worries that it could put the Fed in a box if the economic data shifts to a more positive tone.

"If Janet Yellen can ease this transition, it will be a testament to her ability as a central banker," Krosby said.

Ultimately, the early tone from Yellen is likely to be one of caution. Among the Fed's voices, she has been comparatively skeptical of the recovery's strength, particularly in terms of how much a shrinking labor force has been responsible for the unemployment rate's decline.

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That's where the "open-ended" language associated with QE could come in handy for her—the Fed has left itself enough room actually to increase the pace of purchases should the economic data weaken.

"I expect her to continue with the tapering of $10 billion per month. That will continue until around April and at that point the economy will enter into a recession," said economist Michael Pento at Pento Portfolio Strategies. "You will see a severe pullback in equity values and real estate values. Spiking interest rates will be the cause of that. Sometime in the summer of 2014 Janet Yellen increases the amount of bond purchases instead of tapering."

In that respect, then, her tenure may turn out not so different from that of Bernanke, who has been a consistent supporter of flooding the markets with liquidity to keep the economy moving.

"Where some people call Bernanke 'Helicopter Ben,' she's actually more of a liquidity maven," said Michael Cohn, chief investment strategist at Atlantis Asset Management. "So I don't expect anything different than what Bernanke has been saying."

—By CNBC's Jeff Cox. Follow him on Twitter @JeffCoxCNBCcom.


This story has been updated to reflect the correct time frame for the Fed's transition period.