Growth in M4 excluding "intermediate other financial corporations" – the best measure of the broad money supply, also referred to as "adjusted M4" – rose slightly during the first quarter but remains below a level likely to be consistent with trend economic expansion and on-target inflation over the medium term. The latest figures probably influenced the MPC's decision this week to expand QE.

Annual growth in adjusted M4 edged up from 3.5% in December to 3.9% in March – see first chart. The recovery is more impressive in real terms: deflated by retail price inflation, the annual change has moved up from a low of -0.7% in September to 4.3% in March. This supports expectations that the economy will stabilise during the second half.

Adjusted M4, however, probably needs to grow by 6-7% per annum over the medium term to be consistent with the inflation target. This assumes potential GDP growth of 2% and a decline in velocity of 2.5% pa, in line with the mean over 1992-2004, when inflation averaged close to 2%. Faster expansion than 6-7% is arguably warranted shorter term to support additional economic growth to close the current large output gap.

During the first quarter alone, adjusted M4 grew at a 5.4% annualised pace. This is higher than a 4.0% increase in M4 excluding all financial corporations (i.e. M4 held by households and non-financial corporations). The difference may partly reflect a boost to money holdings of financial institutions (i.e. excluding intermediate OFCs) from the Bank's QE gilt purchases in March. Detailed figures show significant rises in M4 deposits of securities dealers and investment / unit trusts during the first quarter, partly offset by a fall in insurance companies' and pension funds' cash.

Credit expansion is weaker than monetary growth. The annual increase in M4 lending excluding intermediate OFCs (and adjusted for the effect of securitisations) slid further to 2.8% in March from 4.6% in December, although the quarterly change recovered from -2.0% annualised to 2.3%. A key reason for expanding QE is to prevent the slowdown in credit from pulling down monetary growth.

It is difficult to disentangle demand and supply effects on credit weakness. One indication of supply restriction, however, is that credit utilisation rates (i.e. the proportion of arranged facilities actually drawn down) rose further in most industries during the first quarter – second and third charts. Banks are honouring existing lending agreements but appear reluctant to sanction an expansion of credit lines.

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.