Current low monetary growth will not prevent inflation overshooting the 2% target because the velocity of circulation of money is rising fast in response to negative real interest rates. The Bank of England should raise interest rates to stem the fall in the demand to hold money and slow the pick-up in velocity.

Nominal GDP rose at an annualised rate of 3.9% during the second half of 2009 while the broad money supply – as measured by M4 excluding money holdings of non-bank financial intermediaries – fell by an annualised 1.2%. The velocity of circulation of money, therefore, increased by an annualised 5.1% – the largest two-quarter gain since 1999.

The velocity rise is the counterpart of a reduction in the demand to hold money by households and financial institutions, driven partly by a recovery in confidence but more importantly by the negative post-tax real return on bank deposits, which is encouraging a rebalancing of portfolios. Record mutual fund inflows are evidence of this portfolio shift: retail investors bought a net £1.8 billion of unit trusts and OEICs in January, bringing the 12-month running total to £26.4 billion, equivalent to 2.7% of household money holdings, according to Investment Management Association figures released yesterday – see chart.

Post-tax real interest rates were last negative for a sustained period in the 1970s. M4 velocity rose at an average annualised rate of 4.7% over 1974-79.

The 2% inflation target is consistent with nominal GDP growth of 4-5% per annum over the medium term, assuming trend real economic expansion of about 2.5% pa. If velocity were to continue to rise by about 5% pa, this would imply no room for any increase in the money supply. A policy of expanding asset purchases to achieve a positive rate of monetary growth would be misguided, leading to an inflation overshoot.

M4 excluding intermediaries’ money holdings rose by an annualised 1.9% in the three months to January. On current velocity trends, therefore, money growth may already be too strong to achieve the 2% inflation target. Rather than expanding asset purchases, the Bank of England should be considering raising interest rates to stem the flow of funds out of bank deposits and restrain the pick-up in velocity.