World equities have broadly tracked the G7 monetary base (i.e. currency in circulation plus bank reserves) since the Federal Reserve launched QE1 in late 2008. A wide gap, however, has opened up recently as markets have anticipated a further US liquidity injection – see first chart.

The Fed has now launched QE2 by signalling an intention to buy a net $600 billion of securities by mid 2011. The chart shows a projection for the G7 monetary base assuming that 1) it purchases the full amount on schedule, 2) there is no sterilisation of the impact on US bank reserves and 3) the base is static in other G7 countries.

Based on the relationship to date, the projected level of the G7 monetary base in mid 2011 suggests a further 6% rise in equity markets in US dollar terms. Bulls, however, may wish to consider the following qualifications.

First, equities are currently at a level consistent with the projected G7 base in April 2011, i.e. markets may be five months "ahead of the game".

Secondly, the Fed could scale back its intended purchases if economic growth accelerates in early 2011. Such a scenario is suggested by a recent strong pick-up in US real narrow money, M1, which leads activity by about six months – second chart. (QE2 is, at best, unnecessary. There was a stronger case for action last spring, when money growth was weak; instead, the Fed allowed the monetary base to contract, contributing to recent sluggishness.)

Thirdly, even if it buys the full $600 billion, the Fed may choose to sterilise part of the impact on the monetary base, for example by offering banks term deposits or expanding the “supplementary financing programme”, under which the Treasury issues additional bills to soak up liquidity (used during QE1).

Finally, US monetary base expansion may be offset by contraction elsewhere. The Eurozone base, already down by 20% from a summer peak, may continue to decline as the European Central Bank restores pre-crisis liquidity provision arrangements. Further rises in reserve requirements and official rates, meanwhile, are likely in China, where inflation has been driven higher by surging commodity prices caused in part by the Fed’s expansionary policies.