We have seen a slew of recent comments from Fed officials hinting at the possibility that the Fed would do more to make sure the economic recovery does not falter. Those arguing for further stimulus make up the “dove” camp which has been pretty vocal over the last few weeks with the main emphasis coming on helping the struggling housing market.

Recent Dovish Comments from FOMC Members Yellen, Tarullo, Dudley

Janen Yellen, who is Vice Chairman and has a viewpoint similar to that of Bernanke, on October 21st first made the case for more quantitative easing is needed.

From BusinessWeek:“Federal Reserve Vice Chairman Janet Yellen said a third round of large-scale securities purchases might become warranted if necessary to boost a U.S. economy challenged by unemployment and financial turmoil.

The central bank should also give “careful consideration” to Chicago Fed President Charles Evans’s proposal to tie the near-zero interest-rate pledge to specific levels of unemployment and inflation, Yellen said today in a speech in Denver.

“Securities purchases across a wide spectrum of maturities might become appropriate if evolving economic conditions called for significantly greater monetary accommodation,” Yellen said in prepared comments to the annual meeting of the Financial Management Association International.”

Fed Governor Daniel Tarullo, around the same time on October 20th, also made the case for further Fed purchases, with his focus on the housing sector. His position is that the FOMC should seriously look at buying MBS as part of their efforts.

From Reuters Blogs:“I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009 in order to provide more support to mortgage lending and housing markets.

There is need, and ample room, for additional measures to increase aggregate demand in the near to medium term, particularly in light of the limited upside risks to inflation over the medium term.”

NY Fed President Dudley, echoed those sentiment in a speech on October 24th:

From FinancialPost:“Breaking this vicious cycle is one of the most pressing issues facing policy makers,” Mr. Dudley said in a speech at Fordham University’s Gabelli School of Business in New York.

“Clearly we’ve indicated our interest in supporting the housing market in keeping mortgage rate spreads, and spreads between mortgage rates and Treasury yields, from getting too elevated,” Mr. Dudley said. “Depending on how the world evolves, we potentially could move to do more in that direction.”

Has the Fed’s Economic Outlook Improved?

The Fed’s weak economic outlook in the last statement was a catalyst for equities to sell-off. The incoming fundamental data has been slightly better in the last month and so we’ll see how that is reflected in the FOMC statement. But, the same problems – high unemployment, stagnant housing, and strains in global financial markets – remain, and so the Fed’s picture should not get that much rosier. The question would therefore be if the FOMC is concerned enough about recent developments to warrant more stimulus.

Looking for Signs that FOMC Would Support Housing

While the Federal Reserve conducts the open market operations consistent with its $400 billion “Operation Twist” plan, it is clear that members of the FOMC are considering what to do next if the economy showed significant slowdown. Any wording pointing to supporting the housing market would fall in line with the comments we had heard from Mr. Tarullo and Dudley, and should boost risk sentiment as it would imply further stimulative measures by the Federal Reserve.

Last meeting, on September 21st, the FOMC described housing as such: “Investment in nonresidential structures is still weak, and the housing sector remains depressed…

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.”

While the FOMC currently re-invests its MBS, we want to be on the look out for an increase in its total holdings of mortgage-backed securities, if it pursues this form of quantitative easing. The Fed may want to wait an extra meeting to further consider incoming data on the housing sector as well as give more time for “Operation Twist” to work its results.

Does Fed Have Scope for Further Easing?

The concern with further stimulus would be the impact on inflationary expectations.

That concern is valid considering a headline inflation rate of near 4%, though a core annual rate that continues to be within the Fed’s target of 2%. Still, the last 9 months have seen a steady increase in the core rate as well.

However, if we look at medium term inflation expectations by examining 5-year bond yields in comparison to inflation protected (TIPS) 5-year yields we see a “break-even” rate that has declined considerably over the last 5 months – from around 2.5% to 1.8%. That is the expectation of inflation by the bond market.

If the Fed is watching those expectations more than it is watching the current rate of inflation they may feel they have scope to lower further as medium term inflation expectations remain anchored.

Impact on USD – Will the Dovish FOMC Member Comments Be Reflected in the Statement

The USD would react as expected to affect statement. The more stimulus the fed handsets or decides to undertake the weaker the US dollar would be against other currencies other factors held equal. If the fed does not propose further stimulative measures following the comments we’ve had from FOMC officials then the you was dollar might gain as it shows the fed would need to see further deterioration in the economy first before it undertakes further stimulus.