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Sri Thiruvadanthai wrote a fantastic post on monetary policy feedback loops and instability. Anybody who has studied Soros knows that one of his primary market advantages was his understanding of reflexivity and feedback loops. This helped him gauge the stability and staying power of both real and Soros-style false trends. An invaluable skill as feedback loops are a constant in the market, as the Palindrome himself once noted:
At any moment of time there are myriads of feedback loops at work, some of which are positive, others negative. They interact with each other, producing the irregular price patterns that prevail most of the time; but on the rare occasions that bubbles develop to their full potential they tend to overshadow all other influences.
Thiruvadanthai does a great job of exploring the more important of these feedback loops, those of monetary policy origins. Here’s an excerpt.
However, in the real world, the expectations of financial market participants can diverge from the expectations of business executives making capital spending decisions. So, if financial market participants take a rosier view of the future, they can bid up asset prices, but, to the extent business capital spending decisions are driven less by cost of capital and more by demand, business executives may see limited opportunity for fixed investment. In that case, the economy may remain tepid, the Fed will remain accommodative, supporting the asset price speculation. Moreover, to the extent the real economy has considerable slack, the Fed has the freedom to address financial market turmoil, or the Fed Put is closer to the money. In some ways, this describes the situation of the past several years. On the other hand, if the real economy is booming and/or inflation is high, the Fed, driven by real economy considerations, may be constrained in its willingness to pay obeisance to every market hiccup. The Fed Put would be further out of the money.