The year-over-year change in the consumer price index (CPI) bottomed in July 2009 at -2.1%. The current rate of 2.3% is relatively benign, but the upward trajectory of the price change is a little alarming. Adding fuel to the fire, the ballooning Federal Reserve balance sheet and massive government deficits may make it necessary for the government to run the printing presses overtime in order to pay back creditors, thereby devaluing the U.S. dollar.

On the other hand, with the current unemployment rate at 9.9%, capacity utilization barely over 73% and worker productivity surging, cost push inflation should be, at worst, a distant concern. It will most likely take years of very strong GDP growth, if we get it, to bring the unemployment rate back down close to 5%, which many economists consider full employment.

Without lingering cost pressures, why should we worry about rising inflation? This question will be debated for years, no doubt, and only the future can bring resolution.

One thing that is not debatable, however, is the fact that investors are worried about inflation rising. One way to measure their level of anxiety is to look at the break-even rate between Treasury Inflation-Protected Securities (TIPS) and fixed-rate Treasury notes.

As of May 1, 10-year TIPS yielded 1.28%, while a 10-year fixed-rate Treasury note yielded 3.53%, for a breakeven rate of 2.25%. This is up quite a bit from a breakeven rate of 1.77% at the end of July of last year, indicating that inflation expectations have risen over the last nine months.

THE TIPPING POINT

There are many ways to hedge against rising inflation. Among them, investing in TIPS is the most obvious. A simple strategy is to buy the 10-year TIPS and hold it to maturity.

Assuming equivalent reinvestment rates, the TIPS would outperform a fixed-rate Treasury note if inflation averaged above the breakeven rate of 2.25% over the 10-year life of the bonds. For example, if inflation averaged 3.3% (100 basis points above the current year-over-year increase in the CPI), the TIPS would generate an average annual total return of 4.58%-well above the 3.75% return on the fixed-rate bond.

But there are significant risks to the TIPS strategy. For instance, if inflation averages only 1.3% (100 basis points below the current level), the average annual total return from the TIPS portfolio would be a fairly meager 2.64%-assuming a reinvestment rate of 3.5%. In such a low-inflation environment, reinvestment options would probably be very low yielding. Dropping the reinvestment rate on the TIPS to 1.5% would lower the average total return to 2.51% for the TIPS investment.

Keep in mind, also, that both the coupon and the inflation-based adjustments to principal on TIPS are federally taxable as ordinary income. Therefore, for an investor in the highest tax bracket of 35%, the TIPS' average annual return would be adjusted downward by the 35% paid to Uncle Sam each year. This would bring the average after-tax returns in the three scenarios (steady inflation, up 100 basis points and down 100 basis points) to 2.24%, 2.98% and 1.72% respectively (see "Tip of the Iceberg," above). Furthermore, these returns would be lower if tax rates rise, which I believe they almost assuredly will.

BUILD A LADDER

An alternative way to hedge the risk of higher inflation is to ladder tax-free municipal bonds out to 10 years. The simplest way to do this would be to buy 10 bonds, with one bond maturing each year of your ladder out to 2020.

This would require taking more credit risk than simply buying TIPS. While Treasury securities have never defaulted, AA-rated municipal bonds have a 10-year cumulative default rate of 0.03% over the 1981-2008 time period, says the most recent default study from Standard & Poor's.

The laddering strategy will also require locking in yields for various periods corresponding to the maturity dates of the bonds. This means that the market price of the municipal bond portfolio will fluctuate as interest rates change, as will the market price of the TIPS portfolio. For the sake of simplicity, we will assume a buy-and-hold approach to investing so that we don't get too distracted by day-to-day price fluctuations in either portfolio.

Using an AA-rated municipal yield curve from Municipal Market Data as of May 1, we would buy 10 bonds with yields that range from 0.30% for the one-year bond to 3.15% for the 10-year bond. The portfolio would have an initial average yield of 1.79% and an average maturity of about five years.

If inflation expectations and interest rates don't change over the 10-year study period, the average yield of the portfolio would gradually rise to the 3.15% yield of the top of the ladder. This would happen simply because lower-yielding bonds in the lower rungs of the ladder are maturing and getting replaced at the top of the ladder.