Sterling's effective rate index reached a nine-month high on 5 August, the day before the Bank of England's announcement of a £50 billion expansion of its quantitative easing programme. It had fallen by 6.9% by last night's close, with a further move lower this morning. The timing is unlikely to be coincidental. The Bank's gilt-buying may be creating excess liquidity in the economy, helping to explain surging equity and prime property prices as well as the fall in the pound.

The suggestion that monetary conditions are over-expansionary may appear strange given recent sluggish growth in the Bank's favoured broad money measure – 5% annualised between January and July. However, the velocity of circulation of money is probably rising in response to record low interest rates and reviving risk appetite so the current rate of expansion may be more than sufficient to support an economic recovery, implying an excess available to push up asset values, including the sterling price of foreign currencies.

A recovery in velocity is suggested by a recent shift of funds out of savings accounts into cash and accounts used for transaction purposes: "non-interest-bearing M1" – comprising cash and interest-free current accounts – rose by 46% annualised between January and July. Strong retail buying of unit trusts and OEICs is also consistent with a reduced demand to hold money – see earlier post.

Though the figures relate to the second quarter, today's National Statistics release on institutional investment flows provides evidence that some of the liquidity created by the Bank's gilt-buying is flowing overseas. Insurance companies, pension funds and trusts bought £13 billion of foreign shares and bonds last quarter – the highest since the third quarter of 2007.

With the economy recovering and inflation continuing to overshoot the Bank's forecasts by an embarrassingly large margin, the case for a further extension of QE was already looking weak. Sterling's slump adds to the reasons for caution and – if sustained – could lead markets to bring forward expectations for monetary tightening.

G7 broad money has slowed significantly this year, with an estimated rise of only 2% annualised in the six months to August – see first chart. A theme of recent posts is that this weakness is not of undue concern because the velocity of circulation is likely to be rebounding after a plunge in 2008 and early 2009. Expressed differently, the demand to hold cash has fallen in response to record low interest rates and reviving markets so weak monetary growth does not signal insufficient liquidity to support an economic recovery.

Prior posts have also noted that a rise in broad money velocity is likely to be associated with a shift of funds out of savings accounts into cash and accounts used for transactions, implying a pick-up in narrow money relative to broad money. Continued solid growth in G7 M1 – an estimated 7% annualised in the six months to August – is therefore reassuring.

The relationship between velocity and the ratio of narrow to broad money is demonstrated for the US in the second chart. Velocity is normally calculated using nominal GDP and money supply data for the same period but this ignores lags in the transmission mechanism; the measure in the chart divides GDP by M2 six months earlier. For narrow money, "non-interest-bearing M1" is used, comprising currency, traveller's cheques and "demand deposits" – interest-free accounts with a cheque facility.

There is a clear pattern of changes in the narrow to broad money ratio leading swings in velocity. The ratio is currently growing at an annual rate of 10%, which is the fastest since 1992-93, when M2 velocity rose by 4-5% per annum. A similar increase over the coming year would imply a strong rebound in nominal GDP – even if M2 shows little growth.

The April Budget signalled substantial fiscal tightening starting from next year, with cyclically-adjusted public sector net borrowing projected to fall from a peak of 9.8% of GDP in 2009-10 to 4.5% by 2013-14. The current political debate is less about the scale of adjustment required than how it will be achieved.

It is widely assumed that a deficit cut of this size will act as a major growth depressant. Comparable tightening in the mid 1990s, however, was associated with robust economic expansion. Cyclically-adjusted net borrowing fell from 5.4% of GDP in 1993-94 to 0.6% four years later, a decline only slightly smaller than the 5.3 percentage point projected reduction between 2009-10 and 2013-14. Yet GDP growth averaged 3.2% a year between 1994 and 1998 – see chart.

The lesson of the 1990s is that major fiscal tightening need not derail economic expansion providing it can be phased over several years. The risk is that markets will deny policy-makers the luxury of a slow pace of adjustment – a gilt-buyers' strike could push yields sharply higher and force action to be accelerated, with larger negative economic consequences.

Such a scenario could develop but there is currently little sign of any funding constraint. The bond market vigilantes were run out of town years ago, to be replaced by pension fund actuaries and compliant central bankers.

UK net mortgage lending fell from £108 billion in 2007 to £40 billion last year and just £4 billion in the first seven months of 2009. In July alone, net lending turned negative for the first time in the history of monthly data extending back to 1986. This may, however, mark the trough, with mortgage approvals signalling a significant recovery.

Net lending is the difference between gross lending and repayments, which can be broken down into regular repayments, redemptions and other lump-sum payments. Net lending is unaffected by remortgaging activity, which boosts gross lending and redemptions by the same amount (assuming no change in the outstanding loan balance).

The chart compares gross lending minus redemptions with the sum of regular repayments and other lump-sum payments. These "other repayments" have been stable recently. The fall in net lending into negative territory in July reflected a further slump in gross lending rather than stepped-up repayments.

Gross lending minus redemptions, however, should recover significantly, judging from recent data on mortgage approvals, excluding remortgaging. Approvals have been climbing since late 2008 and their current level looks consistent with monthly lending of about £6 billion. With "other repayments" running at just below £4 billion, this suggests a revival in net lending to about £2 billion a month by late 2009.