By Brian O’Connell
Economists at the Federal Reserve and at the U.S. Treasury are fairly satisfied that, for now, the prospect of inflation is a distant one.

That’s one big reason why the Federal Reserve opted to keep its key interest rate unchanged last week. With little or no inflation on the horizon, the thinking goes, the Fed can keep pumping “cheap” money into the economy (which keeps interest rates down) without too much anxiety over forcing consumer prices to go up.

But inflation is a lot like a werewolf waiting for a full moon – sooner or later one is going to come along and trigger a change that could be ugly.

But what if you found a “silver bullet” in the form of a U.S. Treasury investment that “locks in” today’s inflation rate, and rewards you with higher yields as inflation rises again?

So it goes with Treasury Inflation Protected Securities (TIPS). These are Treasury securities whose principal and interest payments are adjusted for inflation. TIPS, which are backed by the U.S. Government, can be purchased by individuals and institutional investors, essentially as a creative form of insurance against the specter of inflation rising again.

The formula for TIPS is fairly straightforward. They’re indexed against a key U.S. Labor Department’s consumer price index. If that inflation barometer floats upward, TIPS bondholders will see their coupon payments rise accordingly. TIPS are Treasuries, so they do pay interest every six months and pay off the principal when the security matures, with the key difference that both payments can be ratcheted up as inflation rises. You can buy TIPS directly from the U.S. Government or for individual investors, buy them via low-fee Treasury funds.

Of course, no investment is risk-free, and TIPS are certainly not excluded from that. If deflation were to accelerate, and consumer prices slid backward, they would drag coupon values down (as has actually been the case in recent months). In more concrete terms, if a major consumer commodity like gasoline, whose price has declined by approximately 60% since mid-2008, continued to decline, then don’t expect TIPS to shine. The good news? The TIPS’ principal balance stays the same, even if deflation knocks prices down.

Consequently, if you agree with the growing number of Wall Street analysts and economists who believe that over $1 trillion in stimulus spending and a proposed $3.4 trillion budget will deplete U.S. financial coffers, and thus boost inflation, then TIPS begin to make sense.

Interest in TIPS is picking up. According to the U.S. Treasury, there was $512.8 billion in outstanding TIPS through March 31. That’s up approximately $40 billion over the same period in March 2008.

Imagine that … an insurance policy against inflation. Perhaps TIPS are an idea whose time has arrived before inflation.

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