The premise of this journal is that the supply of money can diverge from the demand to hold it and the difference – "excess" or "deficient" liquidity – is a key driver of markets and economies.

Implementing the approach, however, requires an estimate of the demand for money, which is unobservable. A starting-point is to assume that underlying demand depends on the level of nominal economic activity. This implies that excess or deficient liquidity expansion will be related to the gap between the growth rates of the real money supply and output.

The chart shows an index of the return on developed-market equities in US dollars relative to the return on dollar cash (three-month eurodollar deposits). The index rises from 100 at the start of 1970 to 249 at the end of November 2009. In other words, equities outperformed cash by 149% over the forty years, or 2.3% per annum.

The shaded areas in the chart define periods when annual growth in Group of Seven (G7) real money supply – on the narrow M1 measure – exceeded the rate of expansion of industrial output, suggesting excess liquidity. Equities have tended to outperform cash during such periods while underperforming when real money lagged output.

On average, equities returned 11.1% per annum more than cash when there was excess money expansion and 5.8% less when liquidity was deficient. A strategy of switching between equities and cash depending on liquidity conditions would have yielded a cumulative excess return of 873% (5.9% per annum) versus the 149% (2.3%) from a buy-and-hold policy.

Interestingly, the results are less impressive when a broad rather than narrow money measure is used to identify the liquidity environment. On average, equities outperformed cash by 6.3% per annum when G7 real broad money was rising faster than output while underperforming by 1.8% at other times.

Changes in liquidity conditions sometimes bypass developed-market equities and have their main impact on other asset classes. For example, money growth shortfalls in 1994-95 and 1997 were associated respectively with G7 bond market weakness and the Asian crisis. Conversely, excess liquidity in 2001-02 propelled property rather than equity markets higher.

Based on partial data, G7 real M1 is likely to have risen an annual 8% in November versus a 6% fall in industrial output, implying still-favourable conditions. Real money, however, has fallen short of output growth over the last six months and the annual rates of change are likely to converge by next spring as economic recovery proceeds and headline inflation rebounds.

A tide of liquidity has lifted most boats this year but is beginning to ebb. This does not preclude a further rally in equities in 2010 but the ride is likely to be bumpier than in 2009 while a sustained advance may depend on cash shifting out of other asset classes, whose prices may suffer corresponding weakness.

With a further rise to 1.9% in November, annual consumer price inflation remains on course to exceed 3% in January, necessitating a sixth explanatory letter from Bank of England Governor Mervyn King to the Chancellor. The November increase was ahead of market expectations but in line with the forecast presented in a prior note.

While commentary will focus on the role of higher fuel prices, the real story is a further pick-up in “core” inflation. Excluding energy, food, alcohol and tobacco, consumer prices rose an annual 1.9% in November, up from 1.8% in October. Had VAT not been cut last December, core inflation would probably stand at 2.7-2.8% (based on an estimate by the Office for National Statistics of the impact of the reduction).

Core inflation has exceeded Bank of England and consensus forecasts by a wide margin this year. The forecasts overestimated the disinflationary impact of rising economic slack while underestimating offsetting upward pressure from the collapse in the exchange rate. The November rise may partly reflect some retailers hiking prices ahead of the VAT reversal.

Further fuel price effects and the dropping-out of last December’s VAT cut are projected to lift headline inflation to 2.6-2.7% this month. This would yield a fourth-quarter average of 2.0%, above the 1.85% forecast in the November Inflation Report. The headline rate may reach 3.2-3.3% in January as VAT is raised before moderating later in 2010, while remaining above the 2% target – see the earlier note.

The retail price headline rate jumped from -0.8% in October to 0.3% in November, in line with the prior forecast, and is on course to reach 4% or higher by next spring. The annual rise excluding mortgage interest costs and housing depreciation climbed from 2.4% in October to 3.0% last month; the VAT reversal, energy effects and recovering house prices will push the headline rise well above this level in early 2010.

At the November Inflation Report press conference, Governor King stated that the Monetary Policy Committee intended to "look through the short-term rise in inflation" but there is a risk that sharply higher headline rates will destabilise inflationary expectations in the absence of any policy response. With fiscal plans widely judged to lack credibility, the UK can ill afford any loss of confidence in the Bank's inflation-fighting determination.

Assuming that Bank of England purchases finish in February, the gilt market faces a six- or seven-fold increase in net supply in 2010-11. A resulting rise in yields is likely to boost pressure on an incoming government to accelerate fiscal tightening.

Revised Debt Management Office (DMO) projections issued with last week's Pre-Budget Report show net gilt issuance – gross sales minus redemptions – of £208.5 billion in 2009-10. The Bank, however, is on course to buy £183 billion of gilts this year, based on current plans for cumulative asset purchases of £200 billion by February. The £200 billion target implies gilt-buying of £198 billion, of which £15 billion occurred in March 2009, i.e. in 2008-09.

The net supply of gilts to the market, therefore, will be only about £25 billion in 2009-10 (i.e. £208.5 billion minus £183 billion), down from £110 billion in 2008-09 and the lowest annual total since 2002-03 – see chart. This fall has contributed to the recent low level of gilt yields – 10-year yields averaged 3.6% in the first eight months of 2009-10 versus 4.2% in all of 2008-09.

Net supply to the market, however, will surge next year, barring an extension of the Bank's buying. The Pre-Budget Report projects a fall in the central government net cash requirement (CGNCR) from £223.3 billion in 2009-10 – inflated by financial rescue costs – to £174.0 billion in 2010-11. Assuming Treasury bills and national savings contribute up to £25 billion to funding this gap (£21 billion in 2009-10), this implies net gilt supply of £149-174 billion, i.e. six to seven times this year's £25 billion.