We all fear inflation. Who wouldn't? No one likes the thought of having to pay $50 for a paperback book, or $8 for a cup of coffee, or $600 for a plane ticket that would have cost you $400 just a few years ago. The picture can get even uglier, if you're unlucky enough to live in an environment of hyperinflation, when prices can double overnight, again and again and again.
So some of us may be cheering the news that inflation has been very low lately. In fact, in recent months, it has been flat to negative. That is good news in some regards, but it can also hurt us. For example, did you know that 401(k) annual contribution limits are tied to inflation? That's why they've been increased in many years, and now stand at $16,500 for most of us.
Well, with inflation dropping the average price level in the U.S., rules governing 401(k) plans suggest that the contribution limit should be decreased, too, to $16,000. This is a new quandary for our friends at the IRS. They're not eager to lower the limit, as it will result in lower savings levels for Americans and smaller retirement nest eggs -- but they may be required by law to lower it. The IRS decision will be revealed by October, when 2010 limits are announced. (A rise in inflation in August and September can help -- and with all the economic stimulus activity, some do expect stronger inflation to rear its head at some point.)
The downside for 401(k)s is just one problem -- here's another: Retirees who look forward to an increased Social Security payment each year may be sorely disappointed. If inflation stays down, there may be no cost-of-living adjustment for recipients in 2010, and perhaps even 2011. Payments have been increased to adjust for the cost of living in every year since adjustments were instituted in 1975. This decision will also be announced by October.
What to do
So prepare for some possible deflation. And know that you can invest accordingly, too. If you expect consumers to have and therefore spend less money, you'll want to focus on sectors with good defensive properties. For instance, consumer staples like Procter & Gamble (NYSE:PG), Kraft Foods (NYSE:KFT), and Colgate-Palmolive (NYSE:CL) should hold up even if people have less money to spend. Similarly, drug-makers like Pfizer (NYSE:PFE) and Merck (NYSE:MRK) and utility companies such as National Grid (NYSE:NGG) can expect demand to hold steady, given that most people can't cut back too much on prescription costs and utility bills. Lastly, businesses like McDonald's (NYSE:MCD) that provide low-priced options for customers may benefit.
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