Ben Bernanke couldn't have gotten his job at a worse time.  The Federal Reserve increased interest rate for about a year and a half before Bernanke took the reins.  This will eventually have a slowing effect on the US economy.  However, it takes between 12 - 18 months for interest rate hikes to work their way through the economy.  Therefore, the first few interest rate hikes had completely hit the economy when Bernanke took over, but there are a host of others in the pipeline.  In addition, he faces an easy-money induced asset bubble in housing, and heavily indebted consumer and oil based inflationary pressures.  In short, Bernanke faces a host of problems that will probably prevent an economic soft-landing from occurring.

More after the jump.

Many economists, though, warn that the soft landing may seem anything but soft, and suggest that the Fed is either too rosy about the looming slowdown or naïve about the difficulty of reaching its goal for inflation.

In practice, the Fed has achieved only one true soft landing -- in 1994-95, when, under the leadership of Alan Greenspan, it was able to slow the economy enough to cool spending and ease inflation pressure but not so much as to cause a big jump in unemployment. But even Mr. Greenspan, whose ability to fine-tune policy made him famous, presided over two formal recessions, in 1991 and in 2001.

This time, many analysts say that the Fed and its new chairman, Ben S. Bernanke, face considerably tougher challenges. Crude oil, at more than $70 a barrel, is selling at prices that would have been unthinkable in 1995. Productivity growth, which was accelerating in 1995, is slowing these days. The dollar, which was climbing against other major currencies in 1995, is declining against most of them now.

Let's look at all the factors mentioned above to see why an economic soft landing is difficult to achieve.

First, here is a monthly chart of oil for the last few years:

While a slowing US economy can dampen US demand for oil, there are still two major growing economies in India and China that will continue to demand more oil and oil based products.  As long as these economies continue to grow at high rates there will be a strong demand based pull on oil prices which the US will have to pay.  In short, slowing US demand for oil will not serve as a complete cure-all to oil's clear upward price trajectory.  And increasing oil prices provide a double-whammy for the US economy.  They increase inflationary pressures and bite into consumer spending - two contradictory economic influences that raise a policy conundrum for Fed policy makers.

Regarding the dollar, the dollar yen trade is still in stronger dollar territory.  The Japanese economy is still coming out of a recession, lowering the value of the yen relative to the dollar.  In addition, there are questions regarding the sustainability of Japan's expansion.  However, the dollar/euro trade is showing a clear sign of weakening as this yearly chart shows:

The dollar has quietly been under assault from various central banks for the last year, who are diversifying away from the dollar and moving assets into euros.  Part of this is simple diversification into multiple assets to reduce risk.  However, there is still a great deal of concern about the US trade deficit and the fact it has not meaningfully decreased over the last few years.  As a result, some of this diversification is a move away from a currency that some perceive to be at risk.  A weaker dollar relative to the euro increases the possibility of importing inflation, which would increase the possibility of the Fed raising interest rates, increasing the possibility of a hard landing.

Then there is the housing bubble, which has been a primary driver of this expansion.  When interest rates are lowered to 0% after adjusting for inflation, people will borrow more money.  The chart below of total consumer indebtedness demonstrates this:

Total consumer debt as a percentage of GDP increased from 74% in the last quarter of 2001 to 91% in the first quarter of 2006.  Consumer spending has increased for the last 50+ quarters. Before this expansion began the US consumer was already spending about everything he made as evidenced by the 2% savings rate in the early 2000s.   However, non-supervisory wages have decreased after inflation for the duration of this expansion.  While low interest rates have kept interest rate payment obligations low, that trend will end with Fed's policy of continued interest rate hikes.   So the US consumer has added to his debt load to pay her expenditures although his pay has not increased.  As rates increase the consumer's interest rate payments will increase forcing him to cut back on consumer spending.

The Federal Reserve is between a rock and a hard   place.  While consumer spending accounts for 70% of US GDP growth, the US consumer's wages have decreased after inflation for this expansion while his debt load had increased.  As interest rates increase, interest rate related payments will increase crimping consumer spending.  The Fed does not want to increase rates so far that consumer spending starts decreasing.  However, the Fed also faces serious inflationary pressures from oil costs, which are partially out of the Fed's control.  In other words, to lower inflationary pressures the Fed has to hit the already heavily indebted US consumer in a pocket book that has no savings to fall back on.

 

In shorter terms, the Fed is screwed.