The government has been able to continue to fund the large budget deficit at low interest rates in recent months because banks and building societies have stepped up gilt purchases, compensating for a reduction in demand from non-bank domestic investors and overseas residents.
Banks and building societies bought £7.7 billion of the £12.8 billion of new gilts sold in April. Over the last six months, their purchases have totalled £36.1 billion, up from £11.4 billion in the prior half-year and equivalent to 91% of net issuance of £39.8 billion.
Overseas buying of gilts, by contrast, fell to £12.4 billion in the six months to April from £33.5 billion in the prior half-year, probably reflecting a slowdown in capital flight from struggling peripheral Eurozone economies. Non-bank domestic investors, meanwhile, sold £8.2 billion of gilts in the latest six months.
Banks are buying gilts partly under regulatory pressure but also because private sector demand for bank loans remains weak. Any revival in credit demand would probably slow the rate of purchases and put upward pressure on gilt yields. For the moment, banks are effectively delivering the QE2 stimulus sought by MPC arch-dove Adam Posen.
Monetary statistics for April also released today show continued weakness in the broad money supply (i.e. M4 excluding money holdings of intermediate other financial corporations, or M4ex). 12-month growth was unchanged at 1.5% while M4ex contracted by an annualised 2.0% in the latest three months. This weakness, however, is probably consistent with a continued economic recovery and inflation overshoot:
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Annual M4ex growth remains within the 0.5-2.5% range in operation since mid-2009. This has been associated with solid expansion of nominal demand and GDP – gross final expenditure rose by 6.2% in the year to the first quarter. The velocity of circulation of money, in other words, has risen and may continue to trend higher as long as real deposit interest rates remain heavily negative.
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The contraction of M4ex over the last three months was caused by money-holders switching into foreign-currency deposits (not included in M4ex), possibly in anticipation of sterling weakness. The addition to such deposits (excluding intermediate OFCs) was an unusually-large £22 billion over February-April. An expanded measure (i.e. M4ex plus foreign-currency deposits) rose by 3.2% annualised in the three months to April.
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Narrow money trends still appear satisfactory: "non-interest-bearing M1" (i.e. currency plus traditional interest-free current accounts) rose by 9.7% in the year to April.
