Fed’s Yellen Warns of ‘Negative Feedback Loop’

A Fed official said yesterday that housing woes are a weight on the U.S. economy that has yet to be resolved, and warned that the Fed may have to contend with a situation where downward market forces feed off of one another. Saying “growth risks are skewed to the downside for the near term,” Janet Yellen, president of the Federal Reserve Bank of San Francisco, suggested that the Federal Reserve may need to take further action to prevent “a negative feedback loop” from gripping the economy.

“In circumstances like these, we can’t rule out the possibility of getting into an adverse feedback loop,” she warned. “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.”

Saying that consumers “are likely to be pretty hobbled” this year, Yellen said that forward-looking developments in the housing market would be likely to further strain consumer spending in 2008.

“House prices have fallen noticeably and the declines have intensified,” she said. “Moreover, futures markets for house prices indicate further — and even larger — declines in a number of metropolitan areas this year.”

Attempting to mitigate the effects of the housing slump by lowering the Federal Funds target rate to 3 percent in recent weeks has clearly come with some cost to inflation; Yellen said current inflation is “somewhat above what I consider to be price stability.” Core inflation has risen 2.2 percent in the past twelve months, and 2.7 percent in the past three months — numbers that were characterized as a ‘disappointment’ by the FRBSF president.

“My overall assessment is that the turbulence in financial markets is due to some fundamental problems that are not likely to be resolved quickly,” she said.

The Wall Street Journal reported that in remarks made after her speech, Yellen said that the Fed remains focused on the downside risks to the economy — but will move to raise rates to prevent inflationary pressures when “the time comes.”