The Bank of England's decision to resume quantitative easing through a further £75bn of asset purchases is a necessary step forward in an economy in which the outlook for private, government and foreign demand is bleak. In order for the move to have a meaningful impact on expenditure and growth prospects it is important that government plans to engage in credit easing (investing funds in instruments that directly support small business lending) are implemented rapidly and on a large scale. Given that the Bank of England, with a relatively thin capital base, is unwilling to take the risk of purchasing asset backed securities directly, the government has said it will engage in credit easing and so bear the default risk, but with the upfront resources effectively provided via the Bank's new and additional support for the gilt market.
The reason that the latest round of QE needs to be combined with credit easing is that portfolio rebalancing is central to almost all the mechanisms through which asset purchases may influence private sector demand, but its increasingly clear that there are frictions that limit such asset substitution. The first point is clear from thinking about the usual channels through which QE may operate
-- QE may flatten out policy rate expectations so that the costs for floating rate debt indexed according to the policy rate remain low for longer, so mortgage customers and small firms gain resources. But the reason we have indexed debt is that banks count on policy rate changes eventually showing up in similar movements in their funding costs, and for that to happen there has to be rebalancing of portfolios away from low yielding bonds to more risky assets. If there is no such rebalancing then banks will be forced to eventually increase the markup of floating rate debt relative to the policy rate, such that any stimulus to the private sector is short-lived.
-- QE may lower corporate financing costs in line with long-term gilt yields, but obviously this is critically dependent on cash injected into the markets being allocated to corporate bonds or equities in place of bonds.
-- QE may depreciate the real exchange rate, which requires that there is rebalancing in favour of foreign assets.
What factors stand in the way of portfolio rebalancing? One of them is that QE focussed on gilts with a long period to maturity means putting low yielding cash in the hands of the insurance companies and pension funds that have traditionally been important investors in long gilts. These institutions are subject to their own capital requirements based on risk-weighted assets. As the risk-weightings on private sector debt are higher than those on gilts, there are likely to be constraints on the extent to which QE funds can be used to improve private sector financing conditions rather than being re-invested in gilts and further decreasing the cost of government debt. The main effect of a stand alone QE would then be to simply widen the spread between interest rates paid by banks, firms and households and those paid by the government. To correct this problem, the government needs to take responsibility for channelling QE money to parts of the private sector that cannot spend and grow without additional credit. Needless to say, this must happen quickly and on a scale that approximates the addition to the QE programme. By offering to buy assets backed by small business loans, the government provides the banks with an incentive to expand that part of their loan books. There will of course be loan default risk to be shouldered by the government that may add to the national debt (even though the upfront purchases do not on the grounds that debt is being used to purchase an asset), but when markets fail due to excessive risk aversion, risk-taking on the part of a policy-maker is exactly what is required.