Proponents of keeping Bank rate at its current 0.5% level for a sustained period argue that substantial economic slack will bear down on inflationary pressures, risking an undershoot of the 2% target over the medium term. There is no dispute that output is currently below potential; the issues are the size of the gap, its "coefficient" in an inflation model and possible offsets from other factors.
 
Most methods for estimating potential output assign a large weight to recent actual data. This is problematic during recessions, when some business activities contract on a permanent basis as capacity is scrapped. Unusually severe credit restriction in the current downturn may have magnified this capacity effect.

Some recent business surveys cast doubt on claims that companies have scope to boost output significantly, at least without a rise in marginal costs. In the latest CBI industrial trends survey, for example, the percentage of firms citing plant capacity as a factor limiting output was close to its long-run average. The implied disagreement with output gap estimates, such as those produced by the OECD, is unusually large – see chart. (There is a similar divergence between US gap estimates and ISM survey evidence of lengthening delivery times, indicating supply bottlenecks.)
 
A generalised "Phillips curve" inflation model should include not only the output gap but also its rate of change, inflation expectations, the exchange rate, global commodity prices and the real level of indirect taxes. The last three factors have been the key drivers of inflation movements in recent years. If sterling continues to weaken, commodity prices remain underpinned by rapid emerging-world growth and indirect tax increases bear a significant burden of necessary fiscal adjustment, these factors may continue to outweigh the disinflationary impact of economic slack.

UK monetary statistics for September are much better than they look on first inspection. The Bank of England's preferred broad money measure – M4 excluding "intermediate other financial corporations" – fell sharply on the month, resulting in a third-quarter contraction of 1.7% at an annualised rate. This would seem to argue strongly in favour of a further expansion of asset purchases at next week's MPC meeting.

On closer analysis, however, the quarterly decline was entirely due to "non-intermediate" financial corporations running down their money balances. Insurance companies, pension funds, trusts and other fund managers reduced their M4 holdings by £10 billion last quarter, presumably reflecting increased confidence in financial market prospects.

M4 excluding all financial corporations, i.e. money holdings of households and non-financial companies, rose by 0.3% in September and 3.8% annualised in the third quarter – the fastest since the second quarter of 2008. This should encourage Bank policy-makers, indicating that liquidity created by official gilt-buying is filtering down to "end-users" responsible for spending decisions.

As well as increasing their sterling deposits, non-financial firms continued to add to foreign currency holdings while repaying sterling and foreign currency bank loans. Accordingly, the corporate liquidity ratio, i.e. money holdings divided by bank borrowing, rose further to a two-year high – see first chart. This ratio is a leading indicator of business investment and hiring.

Further encouraging features of the data include a pick-up in narrow money M1 and a continuing recovery in mortgage approvals for house purchase, suggesting that net mortgage lending will rise to £2 billion a month or higher by late 2009.

Meanwhile, EU Commission consumer survey results for October also released today showed a further strong improvement in confidence, which has now returned to its long-run average. Confidence has recovered much faster than in other major economies – second chart.

The official estimate of a 0.4% GDP decline in the third quarter implies a further widening of the "output gap" – the difference between actual and "potential" GDP. Business surveys, however, suggest that capacity utilisation has stabilised or increased recently.

For example, the Bank of England's agents' survey scores on capacity constraints in services and manufacturing have risen since the spring. The numbers remain very low by historical standards but any increase should, in theory, reflect higher output and – strictly speaking – above-trend expansion.

The chart shows quarterly changes in GDP and a weighted average of the agents' scores. The capacity indicator gave timely warning of the onset of the recession and suggests that output in the sectors covered should have increased last quarter and possibly even in the spring quarter also.

The MPC's judgement about how much weight to give to stronger survey evidence may be influenced by tomorrow's US third-quarter GDP numbers. Purchasing managers' survey results have been similar in the US and UK recently; if US GDP posts a solid increase, as markets expect, this would cast further doubt on the reliability of the initial UK estimate.

October PMI results released next week, and the Bank's latest agents' scores, will also be important. A significant set-back would lend credence to the GDP number; the PMI surveys, however, correlate with equity analysts' earnings revisions, which strengthened further this month.

Eurozone broad money M3 slowed further in September – annual growth fell to 1.8% from 2.6% in August while M3 rose by just 0.8% annualised over the last three months. As in other major countries, however, headline broad money numbers probably understate monetary support for an economic recovery.

A key reason for a more hopeful view is the continued strength of narrow money M1 – up by 12.8% in the year to September and by 16.9% annualised over the last three months.

Secondly, the M3 slowdown has been exaggerated by weakness in financial companies' money holdings – less likely to be reflected in spending decisions. M3 held by households and non-financial corporations rose by an annual 5.0% in September, well above the 1.8% headline rate.

Thirdly, the non-financial corporate liquidity ratio – M3 deposits divided by bank loans of less than five years' maturity – continues to recover rapidly, suggesting improving prospects for business spending. This echoes trends in other major economies – see chart. (The UK publishes September monetary data on Thursday.)