A broad liquidity measure including money-like instruments issued by the public sector has risen at a 10% annualised pace so far in 2009, supporting recovery hopes and justifying the MPC’s caution about expanding the asset purchase facility further. As well as the MPC's gilt-buying, liquidity has been boosted by increased reliance by the Debt Management Office (DMO) on short-term borrowing to finance the fiscal deficit.

The MPC's asset purchases are intended to "increase the supply of money directly into the wider economy which should boost spending", according to the explanation of quantitative easing on the Bank of England's website. In monitoring the impact, the MPC "will pay close attention to the growth rate of broad money, the cost and availability of corporate borrowing, measures of inflation and inflation expectations, and developments in nominal spending growth".

The broad money supply is normally measured by M4, which comprises the non-bank private sector's holdings of notes and coin and a range of sterling-denominated bank instruments including traditional deposits, CDs, securities of up to five years' original maturity, repos and bills. The aggregate has slowed so far in 2009, rising at a 10.4% annualised rate in the first five months, down from 20.1% during the second half of 2008.

M4, however, has been distorted over the last 18 months by a large increase and more recently a fall in money holdings of financial intermediaries – “intermediate other financial corporations (OFCs)” in the Bank's terminology – which mainly act as conduits for interbank business. The financial crisis resulted in banks cutting back traditional unsecured interbank lending in favour of secured forms of lending channelled through these intermediaries, facilitated by the operation of the special liquidity scheme.

The MPC is therefore focusing on an adjusted M4 measure excluding these intermediaries’ money holdings. Accurate statistics for this measure are currently compiled only on a quarterly basis but the Bank of England also makes available a “monthly proxy” based on partial information. Combining first-quarter data with proxy numbers for April and May, adjusted M4 grew by 6.8% annualised in the first five months of 2009, up from 3.0% in the second half of 2008.

This adjusted measure, however, understates liquidity growth because it omits the non-bank private sector's holdings of public-sector financial instruments that are close substitutes for "money" – these holdings have risen substantially over the last year. In particular, Treasury bills and repo borrowing by the DMO are likely to be regarded by investors as having similar characteristics to short-term bank securities and bank repos.

The chart shows annualised growth of adjusted M4 and a broader liquidity measure including holdings of Treasury bills and DMO repos. The growth rates are calculated over six months except for the final data points, which refer to January to May 2009. The broader measure rose by 10.3% annualised over this latter period – much faster than the 6.8% increase in adjusted M4.

In effect, the DMO has been operating its own liquidity creation scheme in parallel with the Bank of England’s asset purchase facility, funding the budget deficit partly by issuing Treasury bills and borrowing on repo rather than selling gilts. The non-bank private sector lent £54.2 billion in these forms in 2008-09 and the first two months of the current fiscal year – equivalent to 28% of the central government net cash requirement over the same period.

A sharp deterioration in money / liquidity trends in late 2007 and early 2008 – particularly after adjusting for inflation – warned of impending economic weakness. The recent pick-up, also more pronounced in inflation-adjusted terms, supports hopes of a recovery from late 2009. It is possible that the MPC is placing some weight on wider liquidity trends, helping to explain last week's decision to slow asset purchases and defer consideration of a rise in the £125 billion target.