The Bank of England's gilt purchases have had a smaller-than-expected impact on the broad money supply. This is partly because liquidity has flowed overseas – see a previous post for more details. In addition, the Bank's purchases have been offset by a fall in demand for gilts from commercial banks. It is the combined buying of the Bank and commercial banks that determines the impact on broad money.

The table shows transactions in gilts by various groups in the six month periods before and after official gilt-buying started in March. Commercial banks increased their holdings by £37 billion in late 2008 and early 2009 but sold £10 billion of gilts between March and August (the latest available month). The £47 billion reduction in their demand between the two periods offset more than one-third of the £133 billion increase in Bank of England buying.

The change in banks' behaviour reflects the huge build-up of cash in their accounts at the Bank of England resulting from the Bank's gilt purchases. Banks needed to boost their liquidity reserves but, since March, have been able to achieve this goal without buying more gilts. Their combined holdings of gilts and central bank cash rose by £83 billion between March and August, up from £43 billion over September-February.

When the Bank of England expanded its buying plans in August, however, it also severed the link between gilt purchases and the amount of cash in banks' reserve accounts, by simultaneously suspending its lending in weekly open market operations. The contractionary effect of this change has outweighed the injection from continuing gilt-buying so banks' cash levels have fallen recently – see chart.

New Financial Services Authority rules require banks to raise their liquid asset holdings significantly further, although the regulations will be applied over several years. With the Bank of England no longer increasing cash reserves, this implies purchases of gilts and Treasury bills. Stronger demand from banks could partly offset the effects on money supply trends and gilt yields of a suspension or slowdown in official gilt-buying.