In a strategy shift, the Fed’s latest round of quantitative easing, commonly referred to as QE III, will target mortgage backed securities rather than U.S. Treasuries. And, importantly, the Fed said it plans to keep interest rates low even after a recovery gains momentum.

The Fed statement said it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

Federal Reserve Chairman Ben Bernanke hinted recently that Fed policy could soon be tied directly to the U.S. labor markets. Without setting specific targets, the Fed’s announcement did just that.

Stock markets soared on the announcement. The Dow Jones Industrial average was up more than 200 points at 3 p.m. EST.

In a statement, the Fed said, "If the outlook for the labor market does not improve substantially, the committee will continue its purchase of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

The disappointing August jobs report released on Friday, which revealed that a meager 96,000 jobs were added last month, seemed to confirm for many that the Fed would act in some significant way to stimulate growth. While the unemployment rate fell last month to 8.1% from 8.3% it was only because 368,000 people left the workforce altogether, apparently having given up hope of finding a job.

“This is basically QE III, but it’s focused on the mortgage market rather than the Treasury market,” said Gus Faucher, senior economist at PNC Financial Services Group in Pittsburgh.

Fed: Housing Market Is Key Recovery
 The new Fed policy suggests that a housing market recovery is key to stimulating labor markets and eventually spurring a full-fledged recovery, Faucher explained. By keeping mortgage rates low -- and possibly pushing them even lower -- through Fed purchases it will hopefully give the fledgling housing recovery some much-needed momentum, he said.

In addition, Faucher said the Fed has made it clear it will act again if it feels the recovery fails to gain traction.
During a press conference Thursday afternoon, Bernanke said the new open-ended policies are designed to “assure the public that the Fed will remain accommodative long enough to ensure recovery.”

"We don't have a single number that captures that, but we anticipate that we'll have to do more and we'll do enough to make sure the economy gets on the right track," he added.

Bernanke, clearly aware of the political ramifications of Fed policy with a presidential election looming, also took pains to explain that asset purchases do not equate to government spending.

The Fed announced a program of mortgage backed securities purchases valued at $40 billion each month. The Fed also said it would extend Operation Twist, a program initiated a year ago designed to shift the central bank’s portfolio toward long-term assets.

“These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative,” the Fed statement said.

In addition, as had been widely predicted, the Fed said historically low interest rates will remain in place through at least mid-2015. Interest rates have been set at a range of 0%-0.25% since December of 2008, during the worst of the recent financial crisis.

 “Information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months. Growth in employment has been slow, and the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment appears to have slowed. The housing sector has shown some further signs of improvement, albeit from a depressed level,” the Fed’s statement said.

The Fed was widely expected to address the stubbornly dormant U.S. economy through some form of intervention intended to serve as a stimulus. Opinions had varied widely over what form that intervention was going to take and, more importantly perhaps, how effective it would be.

How Effective Will the New Plan Be?
Now that the plan has been announced, those doubts have hardly been erased.

“We’re not sure what the economic effects of this program will be – it should help growth and employment on the margin – but of all the announcements the Fed could have made today, this is very nearly one of the most accommodative that could have been reasonably expected,” said Dan Greenhaus, chief global strategist at BTIG LLC.

Critics of the Fed’s long-term low interest rate policy note that the strategy hurts anyone -- notably retirees -- who has invested in fixed income securities such as bonds. Investment returns on bonds are derived through the bond’s coupon which fluctuates with interest rates. Higher interest rates mean higher coupons, which translate into better returns for investors.

Savings accounts have also been all but useless as a means of deriving income as interest rates have hovered near zero for almost four years.

However, the Federal Reserve hopes that keeping pressure on short and long-term rates will create a multiplier effect. Low rates could encourage businesses to borrow and make investments across the economy. Mortgage rates may also fall, helping to make home purchases more attractive and adding to the burgeoning recovery in that sector.

“In determining the size, pace, and  composition of its asset purchases, the Committee will, as always, take  appropriate account of the likely efficacy and costs of such purchases,” the Federal Reserve said, hinting at this cost-benefit analysis.

The Fed chief stressed repeatedly during his press conference that central bank policy alone is not enough to cure high unemployment or ward off a potential recession if the U.S. falls off the so-called fiscal cliff early next year, when dramatic budget cuts and tax increases will occur unless Congress reaches a compromise on government spending and deficit reduction.