Several MPC members not previously known for their devotion to monetary analysis have cited weak broad money supply growth as a reason for expecting inflation to fall below target over the medium term, a prospect warranting consideration of "QE2" asset purchases. The implications, however, of a given rate of monetary expansion for the real economy and inflation depend on the velocity of circulation. The claim that money growth is "too weak" assumes that velocity will be stable or decline but it has risen strongly over the last year and there are grounds for believing that this pick-up will continue.
 
Velocity is defined as current-price GDP divided by the stock of money; it represents the flow of income supported by each unit of cash. Since the start of quarterly data in 1963, broad money* velocity has fallen by 0.5% per annum (pa) on average – see chart. To support sustainable real economic growth of about 2.5% pa with 2% inflation, monetary expansion and the change in velocity must sum to about 4.5% pa. If velocity were to decline at its historical rate of 0.5% pa, this would require an increase in broad money of 5% pa. Put differently, sustained growth at the recent slow pace – 1.6% in the year to August – would support a rise in current-price GDP of only about 1% pa, suggesting renewed economic contraction or a big inflation undershoot.
 
Velocity movements, however, are not fixed or "exogenous" but vary depending on the relative attraction of money as a store of savings. When interest rates on bank deposits fall beneath inflation, as at present, consumers and companies have a strong incentive to economise on cash holdings. This boosts current-price GDP both directly as part of the monetary "excess" is spent on goods and services and indirectly as purchases of other assets push up prices, leading to expansionary wealth and confidence effects. The combination of higher GDP and lower money holdings, of course, is reflected in a rise in velocity.
 
Recent economic and financial trends are consistent with such a process being under way. Current-price GDP rose by a stronger-than-expected 5.7% in the year to the second quarter; with broad money up by only 1.4% in the year to June, velocity surged by 4.3% – the largest annual gain since 1980. Other evidence of a “dash from cash” includes record retail sales of mutual funds, a decline in the "liquidity ratio" of insurance companies and pension funds (i.e. the proportion of portfolios held in money and short-term securities) and generalised strength in asset prices, with equities, bonds, commodities, houses and commercial property all appreciating over the last year.
 
The view that current monetary growth is "too weak" implicitly assumes that the rise in velocity will slow sharply or reverse but it is more likely that the financial shift is still at an early stage, with many consumers and institutions yet to take on board the MPC's message – delivered most recently by Deputy Governor Bean – that monetary savers should expect to suffer a sustained depreciation of their real wealth. When real interest rates were last significantly negative in the 1970s, broad money velocity rose by 39% over six years, or 5.6% pa – see chart. If such an increase were repeated now, money growth of 1-2% pa would deliver a large inflation overshoot.
 
The MPC’s born-again "monetarists" talking up QE2 are playing a dangerous game. Broad money has been rising faster recently – by 4.5% annualised in the three months to August. With banks in better shape, asset purchases could have a much larger monetary impact than in 2009, when cash injections were partly absorbed by capital issues. Combined with the rising trend in velocity, this suggests that QE2 on any significant scale would lead to a further acceleration of current-price GDP expansion, entrenching and possibly extending the recent inflation overshoot.

* "Broad money" here refers to the Bank of England's preferred aggregate M4ex (i.e. excluding money holdings of "intermediate other financial corporations") from its inception in 1998 and M4 for earlier years; quarterly growth rates were chain-linked to derive a break-adjusted level series.

A post in July drew attention to a reacceleration of G7 real narrow money, M1, suggesting that this would be followed by a rebound in global industrial momentum at the end of 2010 after an extended “soft patch”. This revival, it was argued, would be foreshadowed by an improvement in leading indicators in the autumn.

An update last week noted that the pick-up in real M1 had been sustained while the decline in the OECD’s G7 leading index was losing momentum, consistent with an imminent bottom.

Business surveys this week provide further evidence that industrial weakness may be abating. In the US, the future new orders balance in the Philadelphia manufacturing survey jumped to a five-month high in October; this usually leads the national Institute for Supply Management new orders index – see first chart. The Eurozone “flash” purchasing managers survey for October also reported a rise in manufacturing new orders while, in the UK, CBI industrial output expectations strengthened significantly.

The improvement in surveys tallies with a rise in the net proportion of equity analysts upgrading forecasts for company earnings (i.e. the earnings revisions ratio) – second chart.

Against this encouraging backdrop, the Federal Reserve and its local incarnation, the Bank of England, are threatening to lob a monkey-wrench into the economic machinery by embarking on substantial “QE2” asset purchases.  Since growth is not currently constrained by a shortage of money, such an initiative would probably feed directly into prices – either of assets or goods and services.

A key risk is that additional liquidity fuels further commodity price gains, squeezing real incomes in consuming countries and forcing monetary policy tightening in overheating emerging economies; China's "surprise" interest rate rise this week may be a harbinger. Such adverse effects could, in the worst case, abort the incipient global industrial pick-up.

Similarities may be drawn with late 2007, when "pre-emptive" Fed interest rate cuts sent oil prices through the roof, thereby nailing down the coffin lid of the US consumer and removing any remaining possibility of the economy avoiding a recession.

There was little macroeconomic "news" in the Spending Review.

The Chancellor confirmed the current expenditure totals set out in the June Budget. By cutting a further £7.0 billion from the welfare budget and finding other savings of £3.5 billion, however, he was able to moderate the squeeze on departmental current spending, which will be £10.3 billion higher than previously announced by 2014-15.

There is also a small rise in capital spending relative to previous plans, of £2.3 billion by 2014-15. The investment outlook, however, is still grim, with a real-terms fall of 39% between 2009-10 and 2014-15.

"Total managed expenditure" (TME) – current plus capital spending – is projected to peak this year and fall by 3.3% in real terms by 2014-15. Contrary to popular assertion, such a decline is not unprecedented – following the IMF rescue in 1976, real TME was cut by 3.9% in a single year in 1977-78.

As a proportion of GDP, TME will fall from a peak of 47.5% in 2009-10 to 41.0% by 2014-15 – a cut of 6.5 percentage points over five years. This also has historical precedent: the TME share declined by 6.5 percentage points in five years from a peak in 1982-83 and by 5.5 percentage points in five years from 1992-93 – see chart.

A projected 1.2% real-terms reduction in TME in 2011-12, equivalent to about £8 billion, is unlikely to derail the economic recovery. A much greater threat is posed by previously-announced tax measures designed to raise nearly £20 billion next year – see previous post.

Public sector net borrowing excluding the temporary impact of financial interventions (PSNB ex) rose to £16.2 billion in September from £15.5 billion a year earlier. Incorporating a £0.7 billion downward revision to earlier months in 2010-11, however, borrowing still looks on course to undershoot the Office for Budget Responsibility's (OBR) full-year forecast of £149 billion.

The chart shows a crude attempt to adjust the monthly numbers for seasonal variation: adjusted borrowing averaged £11.75 billion in the first six months of the fiscal year, or £141 billion annualised – see chart. The OBR forecast, therefore, implies renewed deterioration over the remainder of 2010-11. This is unlikely because the benefits of economic recovery should grow as the year progresses while much of the £8.1 billion of spending cuts and tax rises announced since the election has yet to take effect.

Central government current expenditure rose by 6.8% in the six months to September from a year earlier, above the OBR's projection of full-year growth of 5.6%. This was more than offset, however, by a 9.2% increase in current receipts, versus a 6.5% full-year forecast.

The figures also indicate that capital spending has yet to be reined back. Public sector net investment was little changed in the six months to September from a year earlier, implying a drastic cut over the remainder of 2010-11 to achieve the OBR projection of a 21% full-year reduction.

The expenditure cuts to be spelt out in tomorrow's Spending Review will be criticised for endangering the economic recovery. In reality, coming tax increases pose a much greater threat to growth next year.

The Treasury claims that 77% of planned fiscal consolidation between 2009-10 and 2015-16 will occur via expenditure restraint rather than higher taxes. The proportion, however, is lower in the early years – only 57% by 2011-12. This is because spending cuts are being phased in while tax rises are front-loaded.

The Treasury's estimate of the split, moreover, may be questioned. Expressed at constant (i.e. 2011-12) prices, total managed expenditure is projected to fall by just £2 billion between 2009-10 and 2011-12 versus a £45 billion increase in current receipts  – see chart. This suggests that taxes will bear 96% of the burden of adjustment by 2011-12 rather than the 43% claimed by the Treasury.

Tax increases announced by either the coalition or the previous Labour government (since the 2008 Pre-Budget Report), with estimates of the 2011-12 yield in brackets, include:

• Rise in national insurance rates offset by higher thresholds / new business relief from April 2011 (£2.6 billion)

• Restrictions on pensions tax relief from April 2011 (£0.6 billion based on previous government's proposals, rising to £4.0 billion in 2012-13)

• Rise in main VAT rate to 20% from January 2011 (£12.1 billion)

• Rise in insurance premium tax from January 2011 (£0.5 billion)

• Bank levy from January 2011 (£1.2 billion)

• Rise in higher-rate capital gains tax to 28% from June 2010 (£0.7 billion)

• Additional 50% higher income tax rate from April 2010 (£3.1 billion, up from £1.3 billion in 2010-11)

• Withdrawal of personal allowance from £100,000 from April 2010 (£1.5 billion, up from £0.9 billion in 2010-11)

These increases dwarf the planned £1,000 rise in the personal allowance (costing £3.5 billion in 2011-12) and a phased reduction in corporation tax (£0.4 billion, rising to £1.2 billion in 2012-13).

US monetary trends continue to strengthen on a variety of measures* – see chart. The broader M2 aggregate has risen at a 5.7% annualised pace over the last six months, the fastest growth rate since June 2009. Money supply weakness late last year and in early 2010 foreshadowed the current "soft patch" in activity so the recent pick-up suggests improving economic prospects for early 2011.

The Federal Reserve, of course, ignores monetary trends – there was no mention of money in Chairman Bernanke's latest speech setting out the case for "QE2". Its actions, therefore, tend to be destabilising – it ceased asset purchases in April 2010 when the money supply was worryingly weak and now plans to resume buying even as monetary expansion picks up. Since the economy is not suffering from a deficiency of money, a further QE2 injection may simply lead to an artificial rise in asset prices or higher goods and services inflation.

* Definitions:
M1 = currency and checkable deposits
M2 = M1 plus savings deposits, small time deposits and retail money funds
MZM = money of zero maturity = M1 plus savings deposits and all money funds
M2+ = M2 plus large time deposits at banks and institutional money funds (author's definition and calculation)
Note: M3 = M2+ plus repurchase agreements and Eurodollar deposits (no longer published)