Is the massive government stimulus of the last several months laying the groundwork for hyperinflation? Or is the economy so sick that deflation or stagflation is only possible. Let’s define the terms again. Inflation results when the demand for money exceeds the supply of money.

People often define inflation as too much money chasing too few goods, and prices climb. Deflation is the reverse of inflation; and so-called stagflation is when inflation kicks in big time while the economy doesn’t grow at all, it “stagnates”. Stagflation is particularly annoying because things cost a lot more while wages and businesses aren’t growing. Many readers can remember the stagflation of the 1970s that were triggered by the 1973 oil shock.

The best scenario is when we have mild inflation and the economy is growing. Normally, a growing economy results in some degree of inflation. Currently we are experiencing very mild inflation, which is a normal result of the financial crises and credit freeze. But as record amounts of money are injected into the system, one has to wonder what the effect will be.

Of course, no one can predict what will happen. I have read many economists’ arguments for both inflation and deflation.  I will go out onto the proverbial limb and predict that inflation will remain completely mild, less than 2 percent annually, for the next couple of years.

First of all, it will take at least two years for consumers and businesses to get through this de-leveraging period. Second of all, interest rates are so low now that the Fed has plenty of leeway to battle inflation using monetary policy, i.e., increase short-term interest rates. In fact the Fed can also use fiscal policy, and buy back treasury bonds, to increase interest rates.

I do see a risk of high levels of inflation several years down the road, after the economy works off its excesses and shifts into high growth mode again. I envision our economy growing like gangbusters again as I am not in the camp who believes we will follow the Japanese no growth model of the 1990s. We have too much talent eager to innovate and create opportunities within a whole slew of industries: alternative energy, traditional energy, material sciences, nanotechnology, semiconductors, biotechnology, to name a few!

I also am not a proponent of the deflation story that rests its arguments on the fact that the labor market is so weak and commodity prices have been in free fall. My expectation is that commodity prices are primed to begin to recover. We are already seeing significant up-ticks in the price of oil. The labor market may recover on a slower trajectory but it is sure to recover in conjunction with a growing economy. So, my short-term (next 12 months) scenario calls for negligible inflation and slight negative economic growth. My intermediate (1-3 years) scenario calls for mild inflation and mild economic growth. My long-term scenario calls for…oh, come on now…it’s silly enough predicting short-term time frames so I think I’ll climb back from that limb and say that I have no clue about the long-term.

But I am completely clued in and comfortable telling you about the wonders of Treasury Inflation-Protected Bonds. These bonds, issued by the government, have been around since 1997 but have only recently gained some real market traction and liquidity. They pay interest twice a year just like a regular bond. But, unlike a regular treasury bond, every six months the principal value is adjusted upwards (for inflation) or downwards (for deflation) based on the Consumer Price Index. The stated interest rate pays out based on the new principal.

So, for example, let’s say you bought a $1,000 bond that promises a 3 percent interest rate. If the inflation adjustment increases the principal by 2 percent, the new principal amount is $1,020. The 3.0% interest rate payout is based on the new $1,020 amount rather than the original bond cost of $1,000.  Therefore, the interest payment for that period would be $30.60 instead of $30. Now, of course, the numbers start to mean something with the more you invest.  Your income return is inflation adjusted.

One more example: Let’s say you invest $50,000 at a stated 3 percent interest rate.  After two years, perhaps I am wrong and inflation gets pretty ugly quickly, and the CPI adjustment is 7 percent. Instead of receiving $1,500 that year, you will receive $1,605 that year. Be aware that TIPs typically state an interest rate less than the rate of regular Treasury bonds and the difference between the two represents the expected inflation rate.

Another benefit of TIPs is that at maturity, which can be in 5, 10, or 20 years, the bond will return the greater of the original amount or the higher inflation adjusted amount. That means that the TIP is protective against a deflation of the asset value in addition to protecting the income from inflation.

These bonds are best used in tax-deferred accounts because taxes are incurred on the difference between the original issue value and any inflated value each year. This is called “phantom tax”.

Let’s be clear, TIPs are great for any portfolio, but only as a portion of your bond portfolio. Every person has their unique financial situation and their best TIP allocation will depend on many factors. Most portfolios should also include quality stocks or mutual funds for growth.

There are several ways you can buy TIPS. You can buy individual bonds through www.treasurydirect.com or mutual funds made up of different TIPs with different maturities or Exchange Traded Funds made up of different TIPs with different maturities.

I look forward to receiving your questions about TIPs or anything else related to investments, retirement planning, or the economy. Send them to: ellen@ascendcapmgt.com and write “Chadds Ford Live” in the subject line.

Have a happy and safe Memorial Day weekend!