Out of all the financial terms being tossed around these days, one of the least understood is deflation.

Most people have at least a basic understanding of inflation and how it affects them. But what is deflation? And what affect does it have on the market and individuals?

In simplistic terms, deflation is when prices drop. Deflation can also be defined as negative inflation. It doesn’t sound too bad, does it?

Well, it can be. According to a recent Fox News article, deflation is actually worse for the economy than inflation. Why? Because deflation causes prices to drop in certain markets, not just in the entire marketplace.

Take the housing market, for instance. Buyers disappeared as lending dried up and house prices took a dive. For some buyers, that sounds like a good thing: buying the home they want at a really great price. However, many buyers look at the falling prices and hold off in hopes of even lower prices.

This can cause a spiral effect, much like spiralling inflation (remember paying $4-$5 per gallon for gas not long ago?), which is a really bad thing for the economy. Let’s break deflation down a bit further:

• Consumers cut spending as lending evaporates
• Companies slow production and cut jobs as consumers spend less
• Consumers spend even less as employment fears take hold

This pattern can continually repeat until an eventual depression hits. But deflation is rare in the U.S. The United States has not experienced a true deflationary period in about 60 years. There have been times of what is known as “disinflation,” or an inflationary slowdown, but not actual deflation.

What does deflation mean to the average person? Well, it could mean anything from losing your job to seeing the price of your home tank to eventually sending the country into another depression. Sounds pretty scary, huh?

Can anything be done to prevent deflation? The Federal Reserve Bank (the Fed), which is the central bank for the U.S., has already cut interest rates down to almost zero (currently, between 0 percent and 0.25 percent). This encourages borrowing, as lending rates are lower.

With lower lending rates, consumers may apply for more credit and begin to spend more. This will discourage deflation. Unfortunately, the credit markets are still sluggish, which means consumers aren’t applying for credit.

No new credit means no new spending, and no new spending can further drive down prices. Since the Fed has already cut rates to nearly nothing, they don’t have any room to cut them further. Some analysts believe that monetary policy becomes impotent when the Fed has the inability to further cut interest rates during times of slow inflation.

There is disagreement regarding this stance. In 2003, the Joint Economic Committee in the U.S. Congress published a paper, “Monetary Policy in Low Inflation/Deflation Environments,” regarding this very topic.

According to the paper, interest rates can be “misleading policy guides in low inflation and deflationary conditions.” The paper also states that it is a much easier thing to prevent deflation than to fix it.

Furthermore, when interest rates are at or near 0 percent (as they are currently), then people are apt to make inaccurate assumptions about the credit and financial markets. Most of the time, when interest rates are this low, they really don’t “say” a whole lot about any given market.

Apparently, outstanding government debt means that the Fed has the ability to purchase various assets and use these assets to incur inflation. These assets can include long-term securities, foreign exchange and even private debt.

The Fed can also commit to keeping rates low for an extended period of time (known as a “precommitment strategy”). Further, the Fed can begin lending directly to financial institutions.

Interestingly enough, the U.S. government is already implementing many of these strategies. Under the Troubled Assets Relief Program (TARP), $700 billion is being used to buy up private debt. Also, the Fed is already lending to individual financial institutions.

The Fed is already discussing buying long-term Treasury securities. Yet it has not committed to doing so.

Not mentioned in the Congressional paper is a program that the Fed has already unveiled. As a condition of the bailout, participating financial institutions are now required to modify the terms of many of their mortgages. So, in addition to using all of the policy instruments the Joint Economic Committee believes imperative to preventing deflation, the Fed is taking even greater steps to provide relief to consumers.

Even though deflation is something to be avoided and current conditions could tip into deflation, there are signs that it isn’t on the horizon. The Fed, in conjunction with the Treasury and the Congress, is using all the monetary policy instruments available to prevent deflation.

TARP, in addition to the current stimulus bill (the American Recovery and Reinvestment Plan), is doing a lot to slow the slide into deflation. With credit becoming more available and consumers getting the help they need (and not just in the form of trickling down from bailed-out corporations), spending should pick up. Then we can return to the good old inflationary days of old.

Many homeowners are stuck with houses that are virtually impossible to unload. With their interest-only loans about to convert to conventional payments, some homeowners are facing mortgage payments too big to pay.

They are saddled with homes they purchased before the house-price crash. Most analysts actually see the recession as a result of the housing market crash.

To begin with, the subprime lending industry began utilizing interest-only loans. Subprime loans are typically given to buyers seen as a poor credit risk by banks. This could be due to many factors, not just delinquencies or bankruptcies, as those with little credit history are in this group as well.

In the past, subprime loans typically meant higher monthly payments due to the higher interest rates charged as a result of the buyer being a poor credit risk. Also, the buyer was usually expected to have some form of down payment. A down payment lowers the interest rate and repayments because the banks see a buyer having their own money in a home as a slight insurance against default.

Most high-risk borrowers were not able to afford a big enough down payment to lower the rate or monthly payments significantly. So only those who could either afford to put up some of their own money or those who could afford high monthly payments would borrow in the subprime market. The advent of the interest-only loan changed that.

Subprime lending, in and of itself, is not a bad thing. But when high-risk borrowers get loans for houses they technically can’t afford, it turns into a powder keg waiting for a match. The interest-only loans that allowed these borrowers to buy houses at inflated prices turned into conventional loans with much higher payments that their owners could not make.

The anatomy of an interest-only loan is something like this:

• There is usually little or no down payment, which means the buyer has little of their own money invested in the loan and is more likely to default when things go south.
• The monthly payments are initially low as they are only for the interest on the loan. This time period of interest-only payments can last for one to five years.
• Once that time period is up, the loan converts to a conventional loan, with higher rates depending on if the loan is attached to the U.S. treasuries or the London Interbank Offered Rate (LIBOR, the rate at which banks lend to each other). If it is based on U.S. treasury rates, then the payments are lower than if based on the LIBOR.

With the way the housing market seemed to be going up and up and up, many buyers believed that they could sell their homes at a higher price before the interest-only term of the loan ended. Unfortunately, the housing market crashed and with it house prices.

How did the housing market crash bring about the recession? It can be broken down as follows:

• Subprime, interest-only loans are given to poor credit risks with little to no down payment, opening the door for future defaults.
• Banks bundled these loans into packages known as mortgage-backed securities and sold them globally.
• When defaults piled up and foreclosures began to abound, investors who purchased mortgage-backed securities lost money.
• These investors stopped purchasing this type of securities, so banks were now on the hook for the bad loans.
• Banks knew that other banks were also carrying the dead weight of bad loans; consequently, they would not lend to each other.
• Credit markets froze as lending ceased and recession hit.

Since homeowners couldn’t afford their payments and subsequently defaulted, banks and investors lost money. Those same banks and investors stopped putting money into the credit markets, and people had trouble refinancing, purchasing new homes and getting regular credit.

This, in turn, led to lowered consumer spending. As consumers weren’t spending, many businesses lost money. When businesses lost money, they didn’t borrow money to expand their business. No expansion and lack of money led to layoffs and cutbacks on hours and production, which led to more defaults and less spending.

Once the economy began to slide and jobs were lost and businesses went bust, many began to lose faith in the market. More investors were holding onto their money and the recession worsened.

As the economic downturn became more pronounced, house prices fell further. Few people could borrow the necessary funds to purchase homes as lending dried up. With more sellers than buyers, many homes are being sold at “fire-house sale” prices.

Also, many people were worried about losing their jobs due to problems their employers were facing. This, of course, meant that spending decreased further.

It is a vicious cycle that occasionally begs the “chicken or the egg” question. Which came first: the house-price crash or the recession? In this case, the crash of the housing market led to the initial economic downturn. But the recession may further push down the price of homes.