When the Bank of England buys securities from an insurance company or pension fund, the initial effect is to boost the institution’s deposit with its commercial bank, while the bank receives a credit in its reserves account at the Bank of England. The rise in institutional deposits constitutes an increase in the broad money supply M4, while the injection of reserves inflates the monetary base M0.

The Bank of England can “sterilise” the reserves impact of this transaction, for example by reducing its repo lending to the banking system or selling bills. However, providing any such operation is conducted with the banking system, there is no reversal of the initial rise in bank deposits and broad money M4.

For this reason, the Bank’s new asset purchase facility is likely to boost M4, even though additional Treasury bills will be sold to finance the scheme. M4 will rise providing 1) the Bank purchases securities from the non-bank private sector and 2) the additional bills are bought by the banking system.

In a speech last night, Bank of England Governor Mervyn King stated that “unconventional” monetary policy measures the MPC might use “would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies ... Provided the additional reserves are not simply hoarded by banks ... such asset purchases can increase the supply of broad money and credit”.

Mr. King is wrong. A positive impact on broad money does not depend on banks’ lending out additional reserves or even on the creation of new reserves. All that is required is that the Bank buys securities from non-banks and that any operation to sterilise the associated increase in reserves is conducted with banks.

This is not a technical point. A key reason for recommending quantitative action is to offset the drag on M4 from weak commercial bank lending. The attraction of the option is that it allows the authorities to influence directly the supply of money and credit, without relying on banks to transmit additional liquidity to the wider economy. Yet Mr. King appears to believe that any positive impact will occur only if “additional reserves are not simply hoarded by banks”.

As documented in a previous post, Mr. King’s speeches tend to be associated with a significant one-day decline in sterling. The effective index was 1.6% below last night’s close at midday.