Two years on from Lehman’s spectacular demise, global investors’ expectations for future US inflation are – still – all over the map, or at least fabulously fat-tailed.

Some fear runaway inflation; others expect intractable deflation. Asset allocation decisions (more gold and more cash!) have reflected this confusion.

And although average inflation expectations might seem well-behaved, a stretched and distorted distribution of risks around that average is a problem, while the mean is (arguably) meaningless.

Frankly, QE2 hasn’t helped.

In part because it has been so baldly misinterpreted as an open-ended license to print money, trash the dollar and drive inflation (much) higher.

But what has been happening to the US money supply these past few years?

To help answer that question and assess price stability risks, we measure US “shadow money” and “effective money,” as we described in our guest slot on FT Alphaville a year ago.

Effective money, our favored broad money aggregate for the US, is the sum of plain old bank money – M2 or savings and checking deposits – and shadow money, which is based on the outstanding value of liquid debt securities which can be repo’d quickly for cash. (The thought is if a $100 security is so liquid that you can borrow, say, $95 in cash by posting the security as collateral, then owning the security will affect your behavior just like owning $95 in cash.)

Because effective money is influenced by monetary policy, fiscal policy, bank balance sheet expansion, and shadow bank credit expansions (e.g. ABS funding of auto loans), our aggregate is broad enough to tell us something useful about the economy and the possible direction of inflation.

Effective money was $27.7 trillion in February 2007 and collapsed to $25.7 trillion by late 2008. Much of the fall was in private shadow money, which suffered from a collapse of funding liquidity (rising haircuts), a sharp fall in bond prices, and very weak net issuance. However, this deflationary shock was offset by a public balance sheet expansion. Later in the recovery private shadow money rebounded, and our latest estimate of effective money is now $33.8 trillion.

Is the $6.1 trillion increase inflationary?

We think not, for several reasons.

First, the increase is not as big as it sounds. It represents just 5.3 per cent annualized growth since Feb 2007 – obviously much more than nominal GDP but not a money stock spiraling out of control. And in recent months, the growth rates of public and private shadow money have slowed, while the growth of M2 has picked up.

Second, it is logical for the quantity of broad money to expand at a time when the demand for safe assets like bonds and cash is very high. Arguably, the lack of this expansion would have been (very) deflationary.

Third, parts of the expansion – especially on the monetary side – are easily reversible with central bank balance sheet and interest operations including the payment of interest on reserves, which could cull any sharp increase in bank credit expansion.

Fourth, although credit expansion has begun to revive in certain places, there really is no sign yet of runaway demand growth in the US. And unemployment and the output gap remain very high.

But of all these reasons, the one we would urge monetarists and inflation worriers to ponder most is the first.

Not very much of what matters about the world is exactly what it seems: and this applies especially to the money supply and government deficits over recent years.

So far at least, we suspect that there has been nowhere near enough money printing to raise the risk, let alone guarantee, runaway inflation.

This entry was posted by Guest writer on Wednesday, December 1st, 2010 at 16:38 and is filed under Capital markets, People. Tagged with inflation, John Law, Jonthan Wilmot, M2, qe, Shadow money. Edit this entry.