If the Bank of England is going to do more QE, it should get ultra adventurous

The Bank of England.

As regular readers will know, I'm not in favour of a new programme of "quantitative easing" for the UK in current circumstances. Not until there is an extreme deflationary threat does it strike me as warranted. That moment may come soon enough, but we are not yet there.

Yet perhaps I've been a little too dogmatic here, for I have assumed that any fresh programme of QE from the Bank of England would, as before, target mainly UK government bonds (gilt edged stock), where yields are already at record lows and where adding yet another source of demand to markets where investors seem unprepared to invest in anything else other than gilts would seem to be close to insane.

If the rate of interest on bonds is already close to zero, it's not clear that pushing it marginally lower still would persuade investors to put their money in higher risk assets. And if that's the primary purpose of QE, then what's the point of doing it?

But there are other ways in which the Bank could help. One quite attractive idea which the Bank has been exploring with the Treasury is that of so called "credit easing", which would be similar in some respects to QE but with significant differences. Instead of injecting new cash into the economy via the purchase of government bonds, the Bank of England would purchase ordinary banking credit.

By targetting credit directly, the Bank of England would be going to the heart of the problem, which is that in a period of vicious deleveraging, there's both a problem with demand for credit and the supply of credit. Bankers tell me that risk aversion has reached a point which threatens another funding crisis, similar to the one that took place in the run up to the Lehman crisis. Interbank funding markets have not yet closed, in the way they did back then, but there is again severe distress.

In circumstances where there are funding difficulties, the supply of new credit will become even more constrained. What the Bank of England must do is provide the funding that markets are refusing. What's proposed is something similar to the Special Liquidity Scheme of early 2008, when the Bank agreed to issue banks with Treasury bills – easily transformed into cash – in return for mortgage securities that at that stage could not be otherwise funded.

But under the SLS, these were legacy assets that the Bank was taking as collateral. What "credit easing" would do is attempt to create new credit by making cash available for new SME lending. The effect would also be to push down the effective interest rate businesses are required to pay for their loans, and thereby reduce what are at present exhorbitant spreads. It's already being done in Japan, and it may be worth a try here.

Sir Mervyn King, Governor of the Bank of England, has made clear that he's against the sort of QE that would involve the Bank in decisions about the allocation of credit, but assuming the Bank is properly indemnified by the Treasury, I can't necessarily see a problem with it.

In an era where bond yields are already as low as low can be, this type of QE promises to be a good deal more effective than simply buying another shed load full of gilts.