Previous posts have discussed the possibility of a V-shaped "Zarnowitz" rebound in global industrial activity – e.g. here. A sharp recovery in new orders indices in the latest round of purchasing managers' surveys is consistent with the early stages of such a pick-up – see first chart. For the scenario to develop, however, credit conditions must ease and solid monetary growth must be sustained.

As expected, the April Federal Reserve survey of senior bank loan officers showed a reduction in the net percentage reporting a tightening of lending standards on commercial and industrial lending. The fall was smaller than in the equivalent UK survey but larger than in the ECB's Eurozone poll. The US reading suggest a stabilisation of industrial output over coming months but needs to improve further to be consistent with a strong recovery – second chart. This is likely if the recent better tone in credit markets is sustained.

The Fed survey also reported a big decline in demand for commercial and industrial loans, which some commentators interpreted as a negative economic signal. This slump, however, is probably connected with heavy destocking, as well as a fall in borrowing to finance share buy-backs. The stocks cycle is now turning, lifting activity and potentially credit demand, while buy-backs are of limited relevance for economic prospects. In any case, credit trends tend to follow not lead output – commercial and industrial loans and the ratio of consumer installment credit to personal income are components of the Conference Board's US lagging economic index.

Credit weakness is of concern only if it translates into slower growth in the money supply, which leads the economic cycle (M2 is included in the Conference Board's leading index). Annual growth in G7 real narrow and broad money measures stood at 11% and 7% respectively in March, suggesting ample liquidity to support a strong economic recovery. Shorter-term trends, however, are less favourable: US M2 rose at an annualised rate of just 2% in the latest 13 weeks, while Eurozone M3 contracted between December and March – third chart.

For a Zarnowitz scenario to play out, money measures need to reaccelerate. This is more likely in the US, where the impact of weak credit demand may fade and the Fed's bond-buying operations will continue to provide a boost, than in Euroland, with the ECB still refusing to embrace QE. (Purchases of covered bonds of €60 billion announced yesterday amount to less than 1% of Eurozone annual GDP and the ECB appears to be planning to sterilise the impact on the monetary base.)

The recent rebound in business surveys was presaged by a rise in the equity earnings revisions ratio (the difference between the numbers of analyst upgrades and downgrades expressed as a proportion of the total number of estimates) – fourth chart. The recovery in this ratio has stalled in recent weeks and, like the money numbers, bears close watching: any relapse could signal less favourable business survey results over the summer, possibly associated with another "growth scare" in markets.

The MPC's announcement of an expansion of QE has come earlier than expected but is warranted by recent news – particularly the disappointing money numbers for March discussed in an earlier post.

The Bank of England will expand its QE operation from £75 billion to £125 billion by extending the current buying programme by a further two months to early August. Purchases are running at about £25 billion a month, with the total currently at £52 billion. The MPC has scope to boost the programme by a further £25 billion within the existing £150 billion authority granted by the Treasury.

The MPC's statement sounds more hopeful on the economy, noting "promising signs that the pace of decline has begun to moderate". This suggests that next week's Inflation Report will retain the optimistic recovery profile shown in February – the MPC's forecasts could be similar to the Treasury's, which have been widely ridiculed. CPI inflation has recently been well above the Bank's projections but the statement claims that a fall below the 2% target is still likely later this year, reflecting favourable food and energy price effects and a sharp easing in pay pressures amid rising economic slack.

Even after today's expansion, the UK's QE operation is smaller than the equivalent US initiative. The Federal Reserve is committed to buying up to $2 trillion of securities by the end of 2009, equating to 14% of US annual GDP. The Bank of England's new £125 billion target amounts to 9% of UK GDP.

The MPC-ometer is designed to predict the outcome of each month's MPC meeting based on incoming economic news and financial market developments. The model, like the consensus, forecasts no change in either Bank rate or quantitative easing plans today. The balance of news over the last month, however, is judged to be slightly dovish, suggesting the MPC may announce an expansion of QE in June when the current £75 billion asset purchase programme reaches completion.

The MPC-ometer includes both growth and inflation indicators. Growth news has been mixed: GDP plunged 1.9% in the first quarter but business and consumer surveys showed a surprisingly large improvement in April, while financial market conditions have eased. Inflation indicators have weakened since last month: the headline CPI increase remains above target but average earnings growth fell to an annual 0.1% in the three months to February and a large majority of manufacturers plan price cuts, according to the April CBI industrial trends survery.

The MPC could, in theory, lower Bank rate further from its current 0.5% level – the Federal Reserve has set a target of 0%-0.25% for US official rates. The Committee, however, judges that a further reduction would deliver little if any economic stimulus, reflecting a likely negative impact on banks' profits and willingness to extend credit. Any further easing of monetary policy should therefore take the form of stepped-up QE; the Chancellor has already granted the MPC authority to expand the programme to £150 billion.

The Bank of England is on track with plans to buy £75 billion of securities, mostly gilts, by early June. March monetary figures, however, showed a disappointing initial impact from QE: the broad money supply M4 rose by just 0.2% from February, with cash held by non-financial corporations falling. This reflects two factors. First, the Bank appears to have bought more gilts from banks and overseas investors than domestic non-banks in March – only UK non-banks' money holdings are included in M4. Secondly, the positive monetary impact of QE was offset by a fall in bank lending to the private sector (a small rise in sterling loans being offset by a contraction of foreign currency credit).

The Bank had bought only £17 billion of securities by the end of March so it is too early to conclude that QE is failing to achieve the MPC's monetary goals. Unless April money numbers show a pick-up, however, the Committee should extend the buying programme at its June meeting, probably for a further three months. Super-low interest rates are providing support to the economy but stronger money supply growth is needed to lay the foundations for a sustainable recovery.

Broad money figures for March show a disappointing initial impact from QE. It is too early to make a firm judgement but the numbers suggest that Bank of England asset purchases will need to be expanded beyond the planned £75 billion by early June to boost monetary growth sufficiently to support a sustained economic recovery. (The Bank has Treasury authority to buy up to £150 billion.)

Monetary trends are best monitored using the Bank of England’s adjusted M4 measure excluding “intermediate other financial corporations” – this removes distortions due to the financial crisis but includes investing institutions’ money holdings, which should be inflated by a successful QE operation. The Bank of England does not release its monthly adjusted M4 estimates but the aggregate is likely to have been little changed in March, since overall M4 rose by only 0.2% on the month, while M4 excluding all financial corporations declined by 0.1%. (The Bank will publish March quarterly data for its adjusted M4 and M4 lending measures on 8 May.)

The Bank of England bought £15 billion of gilts in March, equivalent to 0.9% of adjusted M4. There are two possible reasons why the money numbers have shown little response. First, the Bank may have bought securities mainly from banks and overseas investors rather than domestic non-bank investors – only money holdings of the latter are included in M4. Secondly, a positive impact from QE may have been offset by other influences on M4, such as weak bank lending to the private sector.

Both factors were in play in March. Statistics on gilt transactions by sector show that Bank purchases of £15 billion were balanced by net sales of £7 billion by overseas investors, £6 billion by domestic non-banks and £2 billion by banks – see table. So the direct impact of purchases on M4 was only 40% (i.e. £6 billion out of £15 billion). (The outstanding stock of gilts was little changed in March, with DMO issuance offset by a large redemption. This may have affected the sectoral pattern of transactions.)

Meanwhile, credit weakness was a significant drag on M4: sterling bank lending to households and non-financial corporations, adjusted for securitisations, rose by only 0.2% in March and there was a large repayment of net foreign currency borrowing by UK residents. In addition, while domestic non-bank investors reduced their gilt holdings by £6 billion, they bought £21 billion of other forms of public sector debt, including £10 billion of Treasury bills. The overall public sector contribution to monetary growth – including the impact of the public sector net cash requirement, the Bank’s purchases and other debt transactions – was therefore only £6 billion, or 0.4% of adjusted M4.

While this month’s numbers are disappointing, money trends have improved significantly since last autumn: M4 excluding financial corporations rose at a 4.0% annualised pace in the three months to March after just 0.8% during the the fourth quarter. Annual growth slipped to 2.5% in March but in real terms – relative to retail price inflation – has recovered from a low of -0.6% in October to 2.9% now. This is consistent with improving economic prospects but a further pick-up is needed to lay the monetary foundations for a recovery.

The MPC is likely to wait until its June meeting before deciding to expand its QE operation, partly because it would be unwise to make a judgement about its impact on the basis of just one month’s data, and partly because an expansion of the programme would probably take the form of an extension of buying for a further three months, rather than a step-up in the weekly pace of purchases.