Monetary statistics for September reveal that the Bank of England launched QE2 in early October against the backdrop of the fastest expansion of broad liquidity since the financial crisis. Gilt yields, meanwhile, have been artificially depressed by strong foreign buying related to capital flight from the Eurozone.

Bank of England Governor Sir Mervyn King has cited a contraction in the broad money supply measure M4 as a reason for embarking on more QE – it fell by 1.7% in the year to September. The use of M4 is cynical because its weakness reflects a contraction in the money holdings of “intermediate other financial corporations” (IOFCs), which the Bank has previously argued should be ignored in assessing monetary trends. The alternative M4ex measure that strips out these holdings rose by 2.4% in the year to September. According to the Bank’s website, “M4ex is a more economically relevant measure of broad money than … M4”.

M4ex, however, is itself a deficient measure of liquidity because it omits the private sector’s holdings of foreign-currency deposits and public-sector money-like instruments (i.e. Treasury bills, National Savings and repurchase agreements with the Debt Management Office). A broad aggregate encompassing these items can be calculated from Bank statistics and rose by 3.5% in the year to September – the fastest annual growth in quarterly data since the financial crisis. (This measure has provided superior policy signals over the last decade, clearly identifying monetary excess in 2005-07 while indicating a shortage of liquidity in mid 2008 when M4ex was still rising solidly – a research note providing further details is available on request.)

A growth rate of 3.5% remains low by historical standards but nominal GDP has recently risen faster than money and liquidity, bucking a longer-term tendency to lag. The velocity of circulation, in other words, has increased, probably because negative real interest rates have reduced the demand to hold money – the last sustained upswing in velocity occurred in the 1970s when real rates were similarly negative.

Planned QE2 gilt purchases of £75 billion are equivalent to 3.7% of broad liquidity. QE1 did not result in faster monetary expansion because of a simultaneous effort by companies to repay bank debt and banks to raise capital. With corporate and bank finances much stronger than in 2009, QE2 is likely to suffer less “leakage”. Liquidity growth, therefore, could plausibly rise to more than 5% annually by early 2012 – inconsistent with achievement of the 2% inflation target over the medium term assuming that nominal GDP continues to outpace money.

Today’s statistics also reveal that foreign investors hoovered up £12.0 billion of the £15.0 billion of gilts issued by the DMO in September. Rather than representing a vote of confidence in UK fiscal and monetary policy, strong foreign demand probably reflects capital flight from the Eurozone – the £12.0 billion inflow was the largest since a £13.6 billion purchase in April 2010 as the first Greek crisis was kicking off.