In an article discussing economic prospects and policy options, former MPC member Charles Goodhart has argued that the Debt Management Office should reduce gilt issuance in favour of increased sales of short-term Treasury bills. This is an excellent idea: it would help to arrest the recent worrying slump in broad money supply growth and is a more appropriate response to current conditions than a cut in official rates.

A government running a budget deficit injects money into the economy. If the deficit is financed by selling gilts to the non-bank private sector, the cash injection is reversed, leaving the money supply unchanged. However, sales of Treasury bills are less likely to have this sterilising effect, because they are bought mainly by banks rather than non-banks. So the combination of the budget deficit with Treasury bill financing boosts the money supply.

Annual growth in adjusted broad money M4 – excluding deposits of intermediate “other financial companies” – fell from 13.6% to 6.5% between June 2007 and June 2008. In the second quarter alone adjusted M4 rose by only 3% annualised. I think M4 growth of 6-8% per annum is consistent with achievement of the inflation target over the medium term. A lower rate of expansion would risk unnecessary economic weakness and an inflation undershoot.

Goodhart’s proposal offers a way of boosting monetary growth without cutting official interest rates – risky against a backdrop of high inflation expectations, sterling depreciation and fiscal deterioration. Suppose the DMO switched half of the financing of a £50 billion annual budget deficit from gilt sales to the non-bank private sector to Treasury bill sales to banks. Ceteris paribus, this would boost annual broad money growth by 1.4 percentage points.

As discussed previously, the authorities could also support monetary expansion and the housing market by slowing down the rate of contraction of Northern Rock’s balance sheet.

The Goodhart suggestion is the mirror-image of proposals made in 2006/2007 for the DMO to curb then-rampant monetary expansion by “overfunding” the budget deficit through additional gilt issuance. This would have helped to limit credit and housing market excesses.

The Treasury and Bank of England ignored such proposals at the time. As Goodhart notes, his latest policy suggestion would require more gumption on the part of the authorities than has been shown to date.