Jeremy Warner: Is the Bank shooting at the wrong target in aiming at gilts?

Outlook Chocks away. The Bank of England's latest attempt to get us out of the present mess – quantitative easing – manoeuvred awkwardly on to the runway yesterday. The first "reverse auction" of gilt-edged stock, whereby banks and investment institutions are asked to tender UK government bonds to the Bank which then buys them with newly created cash, couldn't be counted as entirely successful.

Perhaps unsurprisingly, pension funds and other institutional investors were not in the least bit interested and refused to bid for anything at all. The Bank attributes this in part to the fact that institutional investors are not used to dealing directly with the Bank and in any case have not yet had time to think through how they might reallocate the cash they would receive from participation.

A better explanation is everyone is so risk-averse right now that swapping what is still perceived of as one of the safest assets in the world for zero interest rate-yielding cash was not an offer anyone wanted to take. Pension funds are not yet ready to go back into equities and corporate bonds.

The Bank of England achieved more success with the banks, which subscribed to the £2bn of cash on offer more than five times. This is very helpful to the Government, for it drives down the cost of funding the budget deficit.

The Government and the Bank insist there is no overt underfunding of the deficit going on, but in effect that's what it amounts to. If you issue gilts which you later buy back in the market using newly created money, the effect is partially to cancel out the original issuance. This effect is only countered once the stock is sold back on to the market, and that's not going to happen for an awfully long time.

Quantitative easing has been applied in the US for some months now, but so far the Federal Reserve has confined its purchases to corporate bonds and commercial paper, believing that this is the quickest and best way to get the money to where it is most acutely needed. By contrast, the Bank of England initially proposes to target only Government bonds.

The idea is that by so doing, it drives yields on bonds down to such depressed levels it tempts banks and investors into applying their money to riskier assets such as the corporate debt markets or even asset-backed securities. The two central banks hope to achieve the same thing – unclogging credit markets – but by different routes. So far, the Bank's approach has certainly succeeded in depressing longer-dated gilt yields, but it has not obviously yet tempted investors back into higher-risk assets. To the contrary, spreads have been further widening.

This is all uncharted territory, and there are already some weird, Alice-in-Wonderland, effects. Falling gilt- edged yields are causing pension fund deficits, rising like topsy because of the collapse in the stock market, to rocket yet further off the scale. The effect of depressing long gilt yields is to increase the already acute funding problems of pension funds and their corporate sponsors and further increase the costs of buying an annuity. Other forms of saving are also damaged.

Nor is there any guarantee quantitative easing in the manner pursued will have the intended effect of driving investors into riskier assets. To the contrary, the knowledge that the Bank stands ready to buy up to £150bn of gilts might further enhance their investment attractions relative to other assets. Perversely, the effect could be the opposite of the one intended. Tricky stuff, this quantitative easing, never mind how the Bank and the Treasury are ever going to extricate themselves from the tangled web of money now being created.