When the Bank of England buys securities from an insurance company or pension fund, the initial effect is to boost the institution’s deposit with its commercial bank, while the bank receives a credit in its reserves account at the Bank of England. The rise in institutional deposits constitutes an increase in the broad money supply M4, while the injection of reserves inflates the monetary base M0.

The Bank of England can “sterilise” the reserves impact of this transaction, for example by reducing its repo lending to the banking system or selling bills. However, providing any such operation is conducted with the banking system, there is no reversal of the initial rise in bank deposits and broad money M4.

For this reason, the Bank’s new asset purchase facility is likely to boost M4, even though additional Treasury bills will be sold to finance the scheme. M4 will rise providing 1) the Bank purchases securities from the non-bank private sector and 2) the additional bills are bought by the banking system.

In a speech last night, Bank of England Governor Mervyn King stated that “unconventional” monetary policy measures the MPC might use “would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies ... Provided the additional reserves are not simply hoarded by banks ... such asset purchases can increase the supply of broad money and credit”.

Mr. King is wrong. A positive impact on broad money does not depend on banks’ lending out additional reserves or even on the creation of new reserves. All that is required is that the Bank buys securities from non-banks and that any operation to sterilise the associated increase in reserves is conducted with banks.

This is not a technical point. A key reason for recommending quantitative action is to offset the drag on M4 from weak commercial bank lending. The attraction of the option is that it allows the authorities to influence directly the supply of money and credit, without relying on banks to transmit additional liquidity to the wider economy. Yet Mr. King appears to believe that any positive impact will occur only if “additional reserves are not simply hoarded by banks”.

As documented in a previous post, Mr. King’s speeches tend to be associated with a significant one-day decline in sterling. The effective index was 1.6% below last night’s close at midday.

CPI figures for December showed a much smaller decline than expected, probably reflecting sterling’s plunge during 2008 and an associated surge in manufactured import prices – up 14% in the year to November.

Annual CPI inflation fell to 3.1% from 4.1% in December but would have risen but for the VAT cut and lower energy costs. The Office for National Statistics estimates that the Pre-Budget Report tax changes would have subtracted 1.3 percentage points from the annual rate if passed on in full. It also reports that around two-thirds of prices collected in shops had been reduced, either at the shelf or the till, to reflect the lower VAT rate in December. This suggests that annual CPI inflation was depressed by 0.8-0.9 pp (two-thirds of 1.3).

A further negative impact, of 0.3 pp, came from lower energy prices. So annual CPI inflation would probably have risen from 4.1% to 4.2-4.3% without the VAT cut and a slump in world energy costs.

The VAT cut also accounts for the fall in annual “core” inflation – excluding energy, food, alcohol and tobacco – from 2.0% to 1.1%. The ONS estimate of the full CPI effect implies a reduction of 1.7 pp in the annual core rate in the event of full pass-through, or 1.1 pp with a two-thirds adjustment. This suggests annual core inflation would have risen from 2.0% to 2.2% – the highest since September – in the absence of the VAT cut.

The most important parts of today’s package of financial support measures are the new Bank of England asset purchase facility and the commitments by Northern Rock and RBS to expand lending relative to previous plans. These have the potential to have an immediate impact on credit supply and monetary growth.

The asset purchase facility is significantly smaller than equivalent Federal Reserve initiatives but can be expanded at the request of the Monetary Policy Committee. The Fed has bought $335 billion of commercial paper and plans to purchase up to $500 billion of mortgage-backed securities – the $835 billion total is the equivalent of 10% of the broad money supply M2. The Bank’s asset purchase facility has been set initially at £50 billion, equivalent to 2.6% of broad money M4 (a wider definition than US M2).

The monetary impact of this programme will be supplemented by a slowdown in the rate of contraction of Northern Rock’s mortgage book and the commitment by RBS to maintain credit availability to large corporations as well as homeowners and small businesses and increase lending by a further £6 billion over the next 12 months. Rock’s previous business plan implied a further £20-25 billion reduction in its mortgage lending in 2009. If its mortgage book is now stabilised, the Rock / RBS initiatives together could add £30 billion to credit supply in 2009 – equivalent to a further 1.6% of M4.

The initial £50 billion purchase under the Bank of England asset purchase scheme will be financed by issuing Treasury bills, implying no impact on the monetary base – so it does not amount to “quantitative easing”. However, growth in the base has already picked up as a result of the Bank’s expanded lending to the banking system and the priority now is to boost broad money M4. The scheme will achieve this providing 1) the Bank buys assets from UK companies and non-bank financial institutions and 2) new Treasury bills are bought mainly by banks, as is likely. In other words, if successful, the scheme will amount to “printing money” to buy private-sector assets. (In theory, the MPC could request that the monetary base impact of a future expansion of the programme is not sterilised by issuing more Treasury bills, implying “quantitative easing”.)

The other parts of today’s package – in particular, the asset protection scheme and the guarantee scheme for asset-backed securities – have the potential to boost credit supply and monetary growth over the medium term but only if fees are set at non-penal levels. Prior UK financial support measures have been more expensive than equivalent schemes in other countries, reducing their effectiveness.

While welcome, today’s package is not all that might have been desired. In particular, the authorities continue to resist pressure to “underfund” the budget deficit in order to boost M4. This could have an immediate and significant impact in relieving the current corporate liquidity squeeze and would complement efforts to improve credit availability.

Banks and building societies operating in the UK suffered an aggregate net loss after tax and provisions of £5.8 billion in the first three quarters of 2008, according to data obtained from the Bank of England under a freedom of information request. This compares with a net profit for banks alone of £29.0 billion in all of 2007. (The statistics include building societies from the start of 2008.)

The loss over Q1-Q3 2008 was due to a negative contribution of £18.9 billion from dealing activities – probably reflecting write-downs on securitised assets – and provisions of £12.8 billion for bad and doubtful debts. Pre-tax profits excluding dealing and provisions were £26.6 billion versus £40.5 billion for banks alone in all of 2007 – see chart.

Despite the £5.8 billion loss, banks and building societies paid out dividends of £17.9 billion over Q1-Q3 2008. Consequently, their stock of retained earnings fell by £23.6 billion – more than cumulative retentions by banks alone over the previous three years.

Even allowing for a further retained earnings loss in the fourth quarter, the erosion of internal capital last year will have been comfortably exceeded by new capital-raising of more than £70 billion, with the government contributing £37 billion. In other words, despite staggering write-downs and provisions, banks’ and building societies’ aggregate capital ended 2008 significantly higher than a year before.

November trade figures released today are grim and show little evidence of the benefits promised by the many advocates of sterling depreciation, including Bank of England Governor Mervyn King.

The ratio of export volumes to import volumes, excluding oil and erratic items, slumped to its lowest level since December 2007 – see first chart.

Trade adjustment takes time but manufacturers are likely to have been constrained from taking advantage of improved price competitiveness by their lack of access to credit. As previously argued, sterling’s plunge may have contributed to credit restriction by accelerating a withdrawal of foreign funds from the banking system.

Meanwhile, the annual increase in manufactured import prices reached 14% in November and may hit 15-20% soon as a result of the further fall in the exchange rate – second chart. Manufactured imports account for 17% of domestic demand – the 14% rise implies a cut of 2.4% in real domestic purchasing power.

Devaluationists will no doubt argue that trade performance would have been even worse but for the exchange rate fall, while conveniently ignoring its negative effects on spending power and credit availability. The myth that the recovery of the early 1990s depended on a prior collapse in sterling continues to exert a strong influence.

Insurance companies and pension funds increased their liquid assets – currency, bank deposits and short-term money market paper – by £28 billion, or 18%, in the year to September. With the value of their portfolios falling by 10% over the same period, the ratio of liquid to total assets rose to 9.1% – the highest since September 1990.

Even assuming no further addition to liquid assets in the fourth quarter, weakness in markets should have ensured a continued rise in the ratio. In other words, the liquidity ratio has probably now surpassed the 1990 peak and is at its highest level since 1974 – see first chart.

Institutions generally target a stable proportion of liquid assets in portfolios over the medium term. For insurance companies and pension funds in aggregate, the ratio has averaged 5.5% since 1964 and the chart shows evidence of mean reversion.

Suppose insurers and pension funds attempted to reduce the liquidity ratio to its long-run average of 5.5%. Based on the position in September, this would involve a first-round injection of £70 billion into markets. Institutions might take the opportunity to "rebalance" their portfolios towards assets that have underperformed recently, including UK equities and corporate bonds. (Overseas investments have benefited from the fall in sterling.)

The £70 billion of buying, however, would represent only the first stage of a multiplier process. An individual institution can reduce its liquidity ratio by buying assets but if the seller is also an insurer or pension fund the aggregate position is unchanged. Rather than being extinguished, "excess" liquidity is simply transferred to another institution, leading to a further round of buying.

Consider the extreme case of a fixed supply of assets entirely owned by insurance companies and pension funds. Liquidity would circulate between institutions, stimulating further buying, until asset prices rose sufficiently to bring the aggregate liquidity ratio down to its target value. In other words, asset prices would bear the entire burden of adjustment back to equilibrium.

In practice, the supply of assets available to insurers and pension funds is not fixed – higher asset prices will induce other holders (e.g. overseas investors) to sell and originators to issue more. However, the essential point remains – the attempt to restore liquidity equilibrium is likely to involve multiple rounds of buying and a significant impact on asset prices.

Consistent with this explanation, there is historical evidence of a positive relationship between the level of insurance companies and pension funds' aggregate liquidity ratio and future UK inflation-adjusted equity returns – second chart. The line of best fit suggests each 1 percentage point rise in the ratio is associated with a 10% increase in the cumulative real return on equities over the subsequent five years.

One caveat to the above analysis is that institutions may wish to hold a higher proportion of short-term assets in their portfolios than in the past because they have entered into interest rate swap agreements involving payment of a floating rate in exchange for a fixed nominal or real income stream, intended to match future liabilities. This may have raised the "equilibrium" level of the liquidity ratio, although any increase is likely to have been much smaller than the recent actual rise, implying the latter still has positive implications for asset prices.