MPC members have argued that Bank rate cuts and fiscal policy must bear more of the burden of supporting the economy because the “bank credit channel” of monetary policy is impaired. The logic is indisputable but the optimal solution is surely to take direct action to revive credit supply.

In the US, mortgage giants Fannie Mae and Freddie Mac, now under government control, are maintaining lending while the Fed has started to buy commercial paper and mortgage-backed securities on a large scale. The Fed’s recent actions have contributed to the three-month LIBOR / OIS spread falling to 1.8% – well below the UK level of 2.2% – while there are tentative signs of a pick-up in monetary growth.

In the UK, by contrast, state-run Northern Rock is on course to cut outstanding loans by £25-30 billion in 2009 while the Bank of England remains resolutely opposed to Fed-style direct lending to firms and households. Government plans to expand support for small firm credit and offer guarantees on mortgage securities backed by new loans are promising but cannot fully substitute for use of the central bank’s balance sheet.

The Bank’s intransigence is an extension of its refusal to offer lender-of-last-resort support to the banking system on other than penal terms – the special liquidity scheme is much more expensive to access than equivalent Fed or ECB facilities. The penal approach was also in evidence in Mervyn King’s recent suggestion that banks will be forced to raise still more capital if they refuse to expand their lending. The Bank’s October Financial Stability Report contained a detailed discussion of why the government’s £50 billion recapitalisation plan would be sufficient to cushion banks against losses over the next five years even in a severe macroeconomic scenario and assuming a low level of underlying future profits. Mr. King’s apparent U-turn is puzzling and threatens to undermine the confidence-building effects of the rescue package.