The Federal Reserve chief, Ben Bernanke, announced a third “quantitative easing” today, to spur growth and reduce the long term interest rates. He said the Fed will be spending $40 billion every month to buy mortgage-backed securities, until the labor market improves. The Federal Reserve has been worried about the record high unemployment rates.

Ben Bernanke Announces Quantitative Easing as S&P500 Soars

During the Jackson Hole conference, Bernanke had given strong hints regarding QEIII. “We must not lose sight of the daunting economic challenges that confront our nation,” Ben Bernanke had quoted. “The stagnation of the labor market in particular, is a grave concern, not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.”

At the end of a two day meeting on Thursday, the Federal Open Market Committee said, without any strong action “economic growth might not be strong enough to generate sustained improvement in the labor market conditions.” The Fed has decided to keep short-term interest rates near zero, at least until mid-2015. The rates have been near zero since December 2008.

QEIII was approved with 11 to 1 votes. The only person to have dissented was the head of the Federal Reserve Bank of Richmond, Jeffrey Lacker. The FOMC said that if the labor market doesn’t show substantial improvements, it will continue to purchase the mortgage-backed securities and other assets, and employ every policy tool until the improvements are achieved.

Despite maintaining the zero interest rates since December 2008, and the central bank purchasing $2.3 trillion in assets, the unemployment rate has stayed above 8 percent. Skeptics thinks that QEIII won’t have any lasting impact on the economy, and more asset purchases will increase the risk of higher inflation in the long run.

The announcement will have political impacts as well, because Republicans have openly opposed the Fed’s asset purchase plans. Vice Presidential Candidate Paul Ryan said that it will do “more harm than good.” President Obama usually does not comment on Fed policies. The Presidential Candidate, Mitt Romney has also criticized any further easing by the Federal Reserve.

However, Jim Chanos and David Einhorn, are two prominent investors (and Democrats) who have slammed quantitative easing. Many other Democrats oppose further quantitative easing, despite the mainstream portrayal of the action as a partisan debate.

Ben Bernanke thinks that the last two rounds have been effective, adding more than two million jobs. “Overall…a balanced reading of the evidence supports the conclusion that the central bank securities purchases have provided meaningful support to the economic recovery, while mitigating deflationary risks,” he said.

Analysts at Credit Agricole note:

Even a QE-3 would hardly do the job:
“It’s the labour market, stupid!”

So far, only QE-2 is actually a quantitative easing as it has elicited banks into pure cash hoarding, while QE-1 (an emergency action) was credit easing. But QE-2’s ability at capping nominal yields is stumbling against the law of diminishing returns:
the impact of QE-2 is just around half that of QE-1.

While unmistakably signalling a real credit crunch, the QE-2 cash-hoarding also elicited an actual but temporary pent-up in inflation expectations. If it has thus managed to reduce real interest rates, QE-2 has proved unable to prop up wage inflation,
the effective driver of trend price inflation.

Likewise, a QE-3 would just prove that monetary policy alone cannot prop up the labour market, as banks would keep hoarding cash and not lend it. Only a fiscal stimulus funded with (base) money printing could kick start non-deflationary growth via massive transfers to pump-prime consumption.

As a result, only a QE-3 implemented in the primary market combined with Obama’s Jobs Plan of last year could actually and lastingly do the trick. Accordingly, as size too matters, the only viable exit strategy is to follow Keynes and Roosevelt: nurture inflation expectations as long as needed.

If unlikely in the current political context, this is the only option to turn the US economy around, the alternative being just a Japan-style deflation.

The S&P 500 (INDEX.INX) has soared on the news. Currently, The S&P 500 (INDEX.INX)  is up 1.24% to 1454.42.