With the true cost of the US bailout efforts running into trillions of dollars and central banks engaging in quantitative easing, the specter of inflation looms large for investors and policymakers. The real question is whether our monetary and fiscal decision-makers will cut off the easy money in time to contain inflation.

Elected officials have three options going forward: raise taxes and interest rates, cut programs and spending, or allow inflation to reduce the value of our debt. The first two choices are politically fraught, no matter which party is in the ascendancy. And judging by the contentious debate surrounding health care reform and the host of other problems facing the nation, no reelection-minded politician would go down either of those roads.

The path of least resistance for our leadership is to allow inflation to quietly take hold; that way no one is answerable for anything.

Now is the time to begin insulating your portfolio against this eventuality.

An obvious starting point is to build a position in Treasury inflation-protected securities (TIPS). Over the past year these investments have lost a little over 1 percent, but performance has improved as investors become more risk averse and gird their portfolios against future pain. Investors can purchase new issues directly from the US Treasury at www.treasurydirect.gov, or in the secondary market through any broker.

Another option is to purchase shares of a TIPS mutual fund or exchange-traded fund (ETF). Our favorite mutual fund in the category is T. Rowe Price Inflation Protected Bond (PRIPX); iShares Barclays TIPS Bond Fund (NYSE: TIP) is our preferred ETF option.

The iShares ETF is relatively straightforward, holding a laddered portfolio of TIPS and tracking the Barclays Capital US TIPS Index. Formerly a consistent dividend payer, the ETF halted payments last November due to the falling pace of inflation. That situation is likely to reverse itself in coming months, as a rising Consumer Price Index (CPI) is almost inevitable.

T. Rowe Price Inflation Protected Bond isn’t quite so plain vanilla. Required to keep at least 80 percent of assets in TIPS, manager Daniel Shackelford has almost free rein over the remaining assets. That flexible investment mandate enabled the fund to outpace its benchmark and yield just over 1.3 percent while the TIPs market suffered amid lower inflation expectations.

More adventurous investors could also opt for short-term, high-quality bond funds. As inflationary pressures build, the value of income streams generated by long-term bonds declines, pushing down bond prices. Short-term bond funds avoid the worst of those effects, enjoying quicker price appreciation and rising income streams.

To that end, one of the best short-term bond ETFs available is the iShares Barclays 1-3 Year Credit Bond (NYSE: CSJ). At the shorter end of mid-duration, the fund maintains an average credit quality of A and has the flexibility to invest in a variety issues. Well-diversified and yielding over 4 percent, the fund boasts an expense ratio of just 0.2 percent.

The ETF poses more credit risk than a government fund, but holding almost 350 issues provides insulation against defaults.

It’s always possible that our government may prove itself to be more responsible this time around than it has in the past, but until we see definitive action it’s always prudent to hedge your exposures.

WHY TO BUY
PRICE INFLATION PROTECTED BOND (PRIPX, $11.27)
ISHARES BARCLAYS TIPS BOND FUND (NYSE: TIP, $101.25)
ISHARES BARCLAYS 1-3 YEAR CREDIT BOND (NYSE: CSJ, $104.18)

• Monetary pressures on inflation continuing to build

• Expensive health care reform package looming

• Inflation remains the path of least resistance