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    Dear HighTower,

    Is massive inflation on the horizon due to all the government borrowing?

    Liz T.

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    Ms. T,

    There is no question that the national debt in the U.S. has risen dramatically over the past five years, as the government spent tremendous amounts of money in an attempt to pull the economy out of the great recession. According to the IMF, net national debt in the United States at the end of 2010 was roughly $10 trillion. At the end of 2014, that figure stood at nearly $15 trillion.

    A significant amount of the debt issuance was purchased by the Fed, effectively creating money out of thin air. So why would the Fed embark on such a program? Simply stated, the Fed was terrified of deflation. While excess inflation can cause significant problems for an economy, deflation is by far the more feared outcome. Deflation leads to a vicious pattern of behavior in which economic activity grinds to a halt as everyone avoids purchasing goods and services for as long as possible due to the likelihood of prices being even lower in the future.

    The Fed’s actions seemed to have removed the threat of deflation, but we are nowhere near a point of massive inflation in the U.S. economy. In fact, with current core PCE inflation readings of 1.2%, we are still running well below the Fed’s inflation target of 2%. There are a variety of factors for the weak inflation picture in the U.S., but two major economic forces are likely to keep inflation low in the U.S. for quite some time.

    First, China’s investment slowdown is putting downward pressure on global commodity prices and this phenomenon will probably last for several years if not a decade or two. China simply over-invested in housing, commercial real estate, and infrastructure over the past 20 years and are now facing unprecedented levels of excess capacity. This will take a long time to work off and in the interim, commodity prices will stay under pressure.

    Second, the strength in the U.S. dollar is effectively lowering the price of all imported goods. The U.S. imports nearly $3 trillion dollars of goods and services and a stronger dollar makes these imports less costly. We believe the dollar’s strength is here to stay as the U.S. economy is outperforming most of the other developed nations.

    Given the macroeconomic backdrop, we don’t believe inflation is a major threat. In fact, the Fed would like to see inflation about 1% higher than it is today. In the event inflation begins to heat up, the Fed has never been better armed to combat it. The Fed has always controlled short rates, which can be raised to combat inflation, but the Fed’s influence on long rates has been less direct. After compiling a war chest of long-term treasuries over the past couple of years, the Fed is now armed with the ammunition to directly influence long rates as well.  Thus, we believe the Fed has more tools at their disposal today to stop inflation in its tracks if it begins to rise to concerning levels.

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