The recent slide in sterling began on the day the Bank of England announced a £50 billion expansion of its quantitative easing programme. The timing is unlikely to be coincidental. The Bank’s gilt-buying may be creating excess liquidity in the economy, helping to explain surging asset prices as well as the fall in the pound.

The suggestion that monetary conditions are over-expansionary is controversial since broad money supply trends remain sluggish, with the Bank’s favoured measure growing at an annualised rate of only 4% so far in 2009. The impact, however, of supply trends on markets and the wider economy depends on the velocity of circulation of money. Having plunged in 2008 and early 2009, velocity may now be recovering.

Velocity is inversely related to the demand to hold money. A flight from markets as the financial crisis snowballed from late 2007 led to a big increase in money demand but this move is reversing as confidence returns and investors become disenchanted with record-low deposit rates. Despite weak supply growth, therefore, households, firms and institutions may be holding more money than they desire. Their efforts to remove the excess involve an increase in investment in markets and spending in the economy.

The current monetary backdrop echoes conditions between late 2005 and mid 2007 but excess liquidity was then the result of buoyant money supply expansion rather than weak demand. Excess money magnified the credit bubble while causing strong economic growth and, later, a significant inflation overshoot.

This inflationary process, however, was short-circuited when the bubble burst in late 2007. With banks curtailing credit expansion, the money supply slowed sharply while money demand boomed as investors fled risk assets. Excess liquidity in early 2007 was replaced a year later by a deficiency of supply relative to demand. This shortage exacerbated market and economic weakness as households and firms sought to boost cash levels by liquidating investments and cutting spending.

Official support for the banking system and the Bank’s gilt-buying have succeeded in stabilising money supply growth this year while money demand has eased, initially in response to interest rate cuts and more recently as confidence and risk appetite have revived. Several recent developments support the view that excess liquidity is now present.

First, households and companies have been shifting funds out of savings accounts into currency and accounts used for transactions purposes – a typical precursor of increased financial investment or spending. A narrow money measure comprising notes and interest-free current accounts has surged at an annualised rate of 46% so far in 2009.

Another sign of reduced money demand is the strong pick-up in mutual fund inflows, with retail sales of unit trusts and OEICs on course to surpass the 2000 record this year. Institutions have also been putting cash to work, with purchases of securities back up to 2007 levels in the spring quarter.

The deployment of funds by investors has allowed non-financial companies to issue bonds and shares in record amounts, using the proceeds partly to pay down more expensive bank debt. Their liquidity ratio – UK bank deposits divided by loans – has recovered to pre-recession levels, supporting hopes of a revival in business spending.

Higher-than-anticipated cash levels may partly explain markedly more optimistic consumer and business surveys. Consumer confidence has risen by much more in the UK than other major economies, supporting a linkage with the Bank’s unusually aggressive easing.

Finally, while asset prices are influenced by other factors, the strength and breadth of gains are consistent with monetary laxity. In addition to the fall in the pound, recent outperformance of gilts and UK property suggests looser conditions than in other economies.

What are the policy implications? If excess liquidity is present the economy is likely to recover faster than the Bank expects while inflation may continue to overshoot its forecasts, partly owing to renewed sterling weakness. This argues strongly against further easing and suggests that some withdrawal of monetary stimulus may be needed early in 2010 to keep the Bank’s projection for inflation in two years’ time in line with the 2% target.

Calls for a further extension of gilt-buying in November based on weak broad money trends are misguided. It would be unfortunate if officials, having ignored the monetary dimension while the bubble inflated, now place overreliance on broad money numbers when a range of other evidence indicates loose policy. A further monetary boost would risk creating another boom-bust in asset prices and the economy. With sterling already on the ropes, it could also precipitate a full-scale currency crisis.