The UK’s bank recapitalisation plan is unlikely to lead to a near-term revival in credit and money growth. Indeed, the initial impact of the scheme will be to reduce the broad money supply M4, implying a need for offsetting monetary easing measures, including interest rate cuts.

The negative M4 impact arises because a portion of the additional gilts and Treasury bills being issued to finance the recapitalisation will be bought by the non-bank private sector, implying a transfer of money out of bank deposits included in M4 into government coffers. If the entire £37 billion were raised from private non-banks – admittedly unlikely – M4 would be cut by 2.0%, before allowing for second-round effects.

This negative impact would be offset if banks used the funds injected by the government to increase their lending. However, the aim of the scheme is to raise capital ratios to a new higher level that banks will be required to maintain over the medium term, rather than provide them with “excess” capital to support additional balance sheet expansion. In other words, any increase in lending may depend on further capital-raising – arguably made more difficult by the stringent terms of the “rescue”.

The negative impact on M4 would be avoided if the government were to fund the recapitalisation by borrowing from the Bank of England but this would be at odds with current institutional arrangements and EU Treaty obligations discouraging central bank lending to governments.

The Debt Management Office plans to increase sales of gilts and Treasury bills by £30 billion and £7 billion respectively in 2008-09. There is a strong case for boosting the amount to be raised from Treasury bills, since these are more likely to be purchased by banks themselves, thereby avoiding a transfer of funds out of M4 deposits.

Headline M4 expansion rose to an annual 12.2% in September but continues to be badly distorted by the financial crisis. Underlying growth – excluding the contribution of non-bank financial intermediaries – fell from 13.6% to 6.5% between June 2007 and June 2008 and is likely to have slipped further more recently (September data will be available in early November). Underlying M4 probably needs to expand by 6-8% per annum to keep inflation on track to meet the 2% inflation target over the medium term. (This assumes trend GDP growth of about 2.5% and a decline in M4 velocity of 2-3% pa, in line with the average over 1992-2004, when inflation was close to 2%.)