The weakness of UK broad money growth in recent years misled most monetarist economists into underpredicting inflation. The view taken here, by contrast, was that this weakness would be more than offset by a rise in the velocity of circulation of money in response to negative real interest rates. The eroding real value of money, in other words, would result in households and firms wishing to hold less of it. The attempt to get rid of “excess” balances would cause money to circulate faster, with a given stock associated with a higher level of nominal GDP and prices.

An ex post measure of velocity is the ratio of nominal GDP to the broad money stock. (Broad money is defined here as M4 excluding holdings of “intermediate other financial corporations”, or M4ex. Figures before 1998 are estimated by linking to M4.) Velocity bottomed in the second quarter of 2009 and had risen by 6.4% by the fourth quarter of 2011. This represents the largest cumulative increase since the late 1970s, when real interest rates were similarly heavily negative – see chart.

The maximum rate of nominal GDP growth compatible with the 2% inflation target over the medium term is about 4% per annum, assuming 2% trend real economic expansion. The 6.4% rise in velocity over the last 10 quarters implies a 2.5% pa rate of increase. Assuming that velocity continues on its recent trend, therefore, inflation is likely to exceed 2% if broad money growth is more than 1.5% pa. Annual M4ex growth was 2.9% in January and has been above 2% in six of the last seven months. Accordingly, the view here is that inflation will continue to overshoot barring a “shock” that causes money demand to increase.