Weekly US money supply numbers are volatile but the latest figures support claims of a significant acceleration. M2 – currency, checkable deposits, time deposits, savings deposits and money market mutual funds – grew by an annualised 22% in the 13 weeks to 8 December, similar to the peak reached briefly in the wake of the 911 terrorist attacks – see first chart.

The pick-up probably reflects the direct and indirect effects of the Fed’s recent shift to more aggressive forms of “quantitative easing”, involving the central bank supplying credit to households and firms as well as additional liquidity to banks.

The Fed has bought $319 billion of commercial paper since October but its plan to purchase $500 billion of agency-backed mortgage securities has yet to be implemented, suggesting a further boost to come. The latter initiative, however, has already contributed to the 30-year conventional mortgage rate plunging below its 2003 trough, resulting in a surge in refinancing applications that may partly explain the M2 pick-up (to the extent that borrowers take the opportunity to increase their loan balances). Interbank swap rates suggest a further fall in mortgage rates – second chart.

The Fed’s statements about quantitative easing have contained no reference to what level of monetary growth is deemed desirable under current conditions. Policy-makers are probably relying in on markets to signal that stimulus is working and may need to be reined back. However, the Fed’s recent actions may have killed off any remaining “bond vigilantes”, who might be expected to provide early warning of the inflationary implications of sustained rapid monetary expansion by pushing Treasury yields higher.

The 23% plunge in the effective exchange rate over the last 12 months is the largest annual fall since the pound was forced off the gold standard in 1931. The rate of decline is greater than during the 1976 IMF crisis and after sterling’s expulsion from the exchange rate mechanism in 1992 – see first chart.

Policy-makers and economists have cheered on the depreciation on the view that it will support activity at little inflation cost. This is based partly on the favourable aftermath of the ERM decline – growth rebounded in 1993 while inflation fell further. This recovery, however, reflected a revival in domestic demand in response to interest rate cuts – the monetary transmission mechanism was working – more than a boom in net exports. The economy was improving before exit from the ERM, having entered recession in 1990, and a huge negative “output gap” outweighed the inflationary impact of the lower exchange rate.

When the Thai baht collapsed in 1997, the boost to net exports was swamped by a contraction of money and credit as foreign capital fled the country. The UK is not Thailand but sterling’s plunge could accelerate a withdrawal of foreign funds from the banking system, exacerbating the credit crunch.

British banks’ net sterling borrowing from overseas stood at £113 billion in August 2007, just before the run on Northern Rock. Surprisingly, this increased over the subsequent 12 months, reaching £200 billion in August 2008 – so foreigners initially supplied more funds to struggling banks. The trend, however, may have turned: £37 billion was repaid in September and October combined and sterling’s plunge could accelerate withdrawals.

The consensus view that the lower currency carries little inflation risk may also be questioned. The second chart shows annual rates of change of manufactured import prices and the effective rate, the latter inverted. The relationship suggests import cost inflation will reach an annual 15-20% in early 2009. With manufactured imports accounting for 17% of domestic demand, this implies a 2.5-3.5% boost to economy-wide prices, excluding second-round effects. The “output gap” is widening rapidly but its impact should be smaller than in 1992-93 – it turned negative only in the third quarter, according to the OECD. Plunging commodity prices and the VAT cut will ensure significantly lower headline consumer price inflation in 2009 but the decline may fall short of MPC and consensus expectations.

The violent market reaction to the outcome of the Fed meeting is surprising. The Fed funds rate has traded consistently below 0.25% since early December while the quantitative measures described in the statement had already been announced or flagged in Chairman Bernanke's speeches.

The Fed’s recent interventions to boost credit flows and the money supply directly are warranted, although such action could have been taken without cutting official rates to almost zero. However, the risk that the Fed is creating the conditions for another upsurge in inflation needs to be recognised.

Deflation in the US in the 1930s and Japan in the 1990s was associated with a contraction of the broad money supply – see here. The chart shows annual growth rates of three measures of US broad money. None is near the danger zone. (M2 comprises currency, checkable deposits, small-denomination time deposits, savings deposits and retail money funds. M2+ adds large time deposits and institutional money funds, while the liquidity measure also includes Treasury bills and commercial paper.)

The Fed’s actions are already leading to an acceleration – M2 rose by an annualised 17% over the last 13 weeks. There is a good chance that the annual growth rates of all three measures will move into double-digits in early 2009. In the short term, this will provide important support to activity and reduce the (small) risk of the economy entering deflation but the price of success may be a renewed increase in inflation from mid 2010.

A previous post drew attention to a sharp pick-up in US narrow money M1 – currency and checkable deposits, adjusted for flows into sweep accounts. This acceleration continued in November, with the annual rate of change reaching 13%.

Broader aggregates are also now showing signs of improvement. Annual growth of M2 – M1 plus savings deposits, small time deposits and retail money funds – rose to a five-year high of 7.6% in November. Over the last 13 weeks M2 has risen at a 17% annualised rate – see first chart.

The M2 acceleration may partly reflect the Fed’s recent purchases of commercial paper – $312 billion since October – and plans to buy mortgage-backed securities should give a further boost. The latter initiative has contributed to a sharp fall in mortgage rates and a surge in refinancing applications – second chart.

Milton Friedman’s old rule of thumb is that the money supply leads the economy by about six months and inflation by about two years. The recent pick-up, if maintained, suggests the economy will hit bottom some time in early 2009, while fears of sustained deflation are unwarranted.