Adverse Feedback Loop

Janet Yellen and other Federal Reserve officials made some interesting statements this week. I copied and pasted a paragraph from her speech below. The key point is her comment about a negative feedback loop. I do think there is something to be said about the psychology of the markets, as one does wonder about the constant drum beat about "how bad things are," and whether or not investors act on that information. If you are told on a daily basis that things are bad, whether the facts may show something completely different, you may begin to believe "the noise," as I like to call it. However, the cascade effect impacts us all - as folks talk themselves into thinking the economy is in recession - they react by unwinding their portfolios; this selling begets selling. I can see where the feedback loop gets stuck in reverse and the market, economy, and life in general can get mired in the negativity.


Speech to the Chartered Financial Analysts of Hawaii
Honolulu, Hawaii By Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco
February 7, 2008, 7:25 PM Hawaii Standard Time, 12:25 AM Eastern February 8

To sum it up, for the next few quarters, I see economic activity as weighed down by the housing slump and the negative factors now impacting consumer spending. It remains particularly vulnerable to the continuing turmoil in financial markets. My comments haven’t even touched on possible slowdowns in business investment in equipment and software and buildings. I see the growth risks as skewed to the downside for the near term. In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop—that is, the slowing economy weakens financial markets, which induces greater caution by lenders, households, and firms, and which feeds back to even more weakness in economic activity and more caution. Indeed, an important objective of Fed policy is to mitigate the possibility that such a negative feedback loop could develop and take hold.