Broad money trends remain weak: M4 excluding money holdings of non-bank financial intermediaries was unchanged in January and has contracted at a 1.9% annualised rate over the last six months. This weakness, however, is compatible with both a solid economic recovery and inflation overshooting the 2% target.

The key monetary driver of the business cycle is the corporate liquidity ratio – companies' money holdings divided by their bank borrowings. This ratio is a major influence on firms' decisions about capital spending and employment, with the latter driving household income and, in turn, demand. In contrast to aggregate broad money, corporate M4 rose by an annualised 4.6% in the six months to January.

The corporate liquidity ratio forewarned of the recession in 2007 at a time when aggregate money and credit were still rising strongly. It reached a low in early 2009 and has recovered significantly, suggesting an imminent pick-up in business spending and hiring. Excluding the struggling real estate sector, the ratio is above its average level since the late 1990s – see chart.

Firms have been able to rebuild their liquidity despite weak aggregate M4 growth because of a fall in the demand to hold money by households and institutional investors. This partly reflects a revival in confidence in markets; in addition, the negative real post-tax return on bank deposits may be triggering a major rebalancing of portfolios.

The current monetary environment resembles the aftermath of the 1974-75 recession. GDP rose by 6% in the first two years of the subsequent recovery despite a 6% contraction in the real broad money stock. The corporate liquidity ratio increased strongly before this upswing as household and institutional money demand fell in response to negative real interest rates. Inflation accelerated as the recovery developed.

The 1976 sterling crisis was caused partly by fiscal laxity – public sector net borrowing reached 7.0% of GDP in 1975-76 – but monetary policy was also too loose, with interest rates held below inflation and the deficit financed largely through the banking system. Current Bank of England policy is identical to that pursued by the monetary authorities in 1975-76 and carries a significant risk of similarly inflationary consequences.