Has all of the approved and proposed spending by Washington (“What this country needs is a trillion-dollar health insurance plan and a second stimulus package!”) got you worried about higher inflation? Think twice before you dive into the market for “TIPS.”

Treasury Inflation Protected Securities seem like the perfect solution. After all, they’re backed by the full faith and credit of U.S. government and are thus considered default risk-free. And, as their name implies, unlike regular treasury bonds, TIPS are designed to prevent your purchasing power from being eroded by inflation: the coupon, or interest rate, is fixed, but the principal on TIPS is adjusted monthly based on the change in the Consumer Price Index [CPI].

Sounds great, right? Except that you need to remember that the cost of living doesn’t always increase. In addition, like all fixed-income securities, TIPS are also affected by changes in interest rates: they can gain value when rates decline and lose value when they go up.

“TIPS are a little complicated,” says Alan Skrainka, chief market strategist at the brokerage firm Edward Jones. John Hollyer, co-manager of the Vanguard Inflation-Protected Securities Fund, says “the most common misperception I can think of is that people know it’s a treasury [security that is] indexed to inflation, so they assume it has no risk. They’re surprised when its price changes.”

Take last year. For 2008, the CPI was 3.8%, just slightly higher than the long-term average. But that hardly tells the whole story. From January through July, inflation was going up an average of 0.6% per month. Then, starting in late summer the extent of the sub-prime mortgage problems began to become apparent, real estate prices fell, major financial institutions teetered on collapse, the government announced the first “bailout” package to forestall an economic calamity, and oil prices plunged. From August through December the cost of living actually fell 0.9% per month. November’s CPI was a negative 1.9%.

Since the value of a TIPS is adjusted monthly for the change in inflation, the bonds fell sharply in the last half of ‘08. And, although the interest rate is a fixed percentage, when the value of the underlying TIPS declines, so does the amount of interest it pays. That can be a shock to a retiree who thought TIPS would provide a stable stream of income.

Although TIPS prices re-bounded earlier this year, thanks to a return of mild inflation, a number of economic gurus think deflation could return- at least in the near-term. If you agree and can’t stomach the possibility that your TIPS could- even temporarily- lose value, then you would want to steer clear of them for now. It comes down to this: from an investment standpoint, for TIPS to do well, there has to be at least moderate inflation.

Because of the slow economy, neither Vanguard nor Edward Jones is expecting inflation to take off in the near-term. “A move to 3% or higher is a possibility longer term,” says Hollyer, adding that “we’re definitely not calling for double-digit inflation.” According to Edward Jones’ Skrainka, “We expect inflation to get back to 3%. We’re not as concerned about hyper-inflation,” which is what we experienced in the 1970s and early 1980s.

There’s another possibility that would be unfavorable to TIPS: stable, [read: flat] prices -- especially if this is coupled with higher interest rates.

Think it can’t happen? Imagine that in order to make it attractive for domestic and foreign investors to finance the budget deficits we’re creating, the federal government has to increase the interest rate its pays on Treasury bonds. As mentioned, like all fixed income investments, TIPS will lose value if rates go significantly higher. According to Skrainka, if the interest rate on the 10-year treasury went from around 3% to 6%, the price of TIPS would “get hammered.”

If you’re a Baby Boomer like me, you probably have a hard time imagining that the cost of living over, say, the next ten years might be negative or flat. After all, the seminal economic event that our generation experienced was the double-digit inflation of the 70’s and early 80’s. From 1974 through 1981 the Consumer Price Index averaged 9.4% per year, hitting a high of 13.5% in 1980. In Skrainka’s words, “We’ve been fighting the specter of inflation our whole careers.”

That can cloud your judgment. You at least have to consider the possibility that inflation is not inevitable. It’s happened before, most notably during the Great Depression.

Still, things would have to get pretty bleak for that to happen.

Bet you never imagined that one day you’d think that (moderate) inflation was a good thing!

Next week: How much inflation is enough to make TIPS an attractive investment?

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.