UK broad money – as measured by M4 excluding money holdings of "intermediate other financial corporations" – probably needs to grow by 6-7% per annum over the long run to be consistent with sustainable economic growth and the 2% inflation target. This assumes a decline in the velocity of circulation of about 2% pa, in line with the trend over 1992-2004, when CPI inflation averaged close to 2%. (Trend growth of 2.5% plus 2% inflation and a 2% velocity decline implies a required 6.5% pa increase in broad money.)

In late 2008 annual broad money growth was below 4% and falling. A post in February therefore argued that the MPC needed to buy assets from the domestic non-bank private sector on a scale sufficient to deliver a five percentage point monetary boost. This was estimated to require purchases of at least £125 billion. The following month the MPC announced a purchase programme of up to £150 billion; this was expanded to £175 billion at last month's meeting.

Broad money has accelerated as a result of this initiative but by less than expected, with a 4.9% annualised increase in the first seven months of the year. Many monetarist economists argue that, unless coming figures improve sharply, the MPC should expand asset purchases further in November and continue buying until money growth reaches at least 6%. (See, for example, the minutes of the last Sunday Times Shadow MPC meeting, available on David Smith's blog.)

While faster growth is likely to be required over the long run, however, there are reasons for thinking that the recent modest pace of monetary expansion is consistent with a solid recovery in 2010 and does not pose a downside risk to the inflation target. On this view, the MPC should be cautious about expanding asset purchases any further, particularly given uncertainty about the lagged effects of buying to date.

The first point is that slow money growth in 2008-09 is partly just pay-back for excessive strength in earlier years. The annual increase averaged 10% over the three years 2005-07, implying a cumulative deviation from a 6.5% long-run norm of 10-11 percentage points. This has been partly absorbed by a cumulative inflation overshoot of about 3 percentage points but there remains an excess of 7-8 percentage points available to finance future economic growth. If this excess were to be eliminated by the end of 2010, broad money growth over 2008-10 would need to be about 2.5 percentage points below the 6.5% pa norm, i.e. about 4%. Recent trends are broadly consistent with this scenario.

Expressing the same point in a different way, the decline in velocity has averaged 4.5% pa since the end of 2004, much larger than the prior 2% trend. The fall last year may have reflected households and companies hoarding cash because of extreme uncertainty about financial and economic prospects. With interest rates at record lows and markets reviving, this velocity slump may now be reversing, in which case 4-5% money growth is more than sufficient to support a strong recovery and on-target inflation.

A prior post on recent US monetary trends suggested that a recovery in broad money velocity ought to be associated with a shift of funds out of savings accounts into cash and transactions deposits, implying a pick-up in narrow money relative to the broader measure. Consistent with this suggestion, notes and coin in circulation rose by 7.6% annualised over January-August, above the 4.9% growth rate of broad money up to July. Historically, "non-interest bearing M1" – comprising cash and sight deposits with no advertised interest rate – has also conveyed useful information. This measure is not officially recognised but can be calculated from published Bank of England data: annual growth was 23% in July – see first chart. (Note that this does not reflect banks cutting the interest rate on some sight deposits to zero, since the "non-interest bearing" definition covers accounts with no ability to pay interest, not those with a current zero rate.)

Monetarist arguments for a further expansion of asset purchases also cite the small scale of the recovery to date in the corporate liquidity ratio – private non-financial firms' M4 money holdings divided by their sterling bank borrowing. A wider definition including foreign currency deposits and borrowing has shown a larger pick-up – see chart in previous post – but either version of the ratio is still well below the long-run average. However, a sectoral analysis suggests that deficient liquidity is concentrated in the real estate and construction sectors, while some industries (e.g. manufacturing) have ample cash. The aggregate ratio excluding real estate and construction is in the middle of its historical range – second chart. This supports hopes of an early recovery in business spending (outside the real estate sector) and is also easier to reconcile with national accounts data showing a record corporate sector financial surplus (i.e. undistributed income minus capital spending).