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.

During the presidential election of 2008, Barack Obama enjoyed the backing of just about his entire party (excluding some disappointed Clinton supporters). Now that he has taken office and has proposed his economic stimulus package, the American Recovery and Reinvestment Plan, many moderate Democrats aren’t as supportive.

The American Recovery and Reinvestment Plan is an encompassing plan to create new jobs; enhance technology and energy efficiency; and upgrade/improve roads, bridges and schools. Many economists believe this plan is one of the best ways to pull our economy out of recession. So what’s the problem?

More liberal Congressional Democrats do not believe the plan goes far enough. Unfortunately, many Republicans think the plan goes too far in the direction of social welfare and less in the direction of helping small businesses and allowing the effects to trickle down to consumers. Hence, there’s the problem of trying to please his own party and the opposition party in order to ensure quick passage of a much-needed bill.

The Democrats believe the program should focus more on job creation and infrastructure improvements (particularly in the energy sector) versus tax cuts (which are included in the bill). Senate Democrats also want to include a provision for bankruptcy courts to have the ability to change the terms of home loans - which is opposed by Republicans.

President Obama has stated that quick passage of the bill is necessary to help the economy begin to improve. Unfortunately, it is impossible to please everybody. Conservative Democrats and Republicans are concerned with the amount of spending in the bill leading to an increased deficit. But more liberal Democrats are chiefly concerned that not enough money is spent on social programs and improvements in infrastructure.

Despite opposition from conservative members of the Democratic Party as well as the Republicans, President Obama has some pretty powerful friends. Speaker of the House and fellow Democrat Nancy Pelosi has called for passage of the bill by President’s Day. As a staunch proponent of this bill, Speaker Pelosi has also stated that if the bill is not passed by President’s Day, then the House will not recess for the day.

By and large, though, Democrats view this bill and President Obama favorably. After all, Obama’s economic plan is a far cry from the Emergency Economic Stabilization Act of 2008, which introduced the Troubled Assets Relief Program (TARP), a $700 billion financial market bailout.

TARP got off to a rocky start when former Treasury Secretary Henry Paulson went against the clear intent of the bill (buying up “troubled assets” such as bad loans from banks and other financial institutions) to invest the initial $350 billion directly in the beleaguered institutions. More oversight has been called for, but ultimately, TARP will do virtually nothing to help the average American.

The American Recovery and Reinvestment Plan, on the other hand, adheres to the Democratic ideas of spending federal funds to improve the state of the nation. Democrats are pleased with the infrastructure, electricity (including alternative power sources), education and other means of creating jobs.

Recently, Rep. Barney Frank (Democrat – MA), chairman of the House Financial Services Committee, appeared on Larry King Live to defend the economic package. He pointed out that the plan created jobs in ways many Republicans and conservative Democrats were decrying as adding pork, such as providing money to fight sexually transmitted diseases. Rep. Frank asked pointedly, “[D]o you think people fight sexually transmitted diseases as volunteers?”

His point is valid. Many on the conservative side tend to view those parts of the stimulus package that promote improvements in infrastructure as the only ones that create jobs. However, manual labor is not the only job option out there.

Rep. Frank also pointed out that many Democrats believe the initial $350 billion from TARP was mishandled by the Bush administration. He further supported President Obama by categorically stating the second $350 billion provided by TARP would be spent in better ways.

Later in the same Larry King segment, Paul Begala, a Democratic strategist, also talked up the plan. Begala stated he believes Obama’s plan can be trusted, as many American people, especially many Democrats, trust Obama himself. He also compared President Obama’s plan to FDR’s New Deal in that it calls for greater transparency and oversight of the money being spent.

Transparency from the Obama Administration is reassuring to many Americans. As the Bush Administration was exiting, no one had any real idea how the money was getting spent or where Secretary Paulson was spending it.

The majority of the Democratic Party is standing firmly behind President Obama. Those Democratic detractors of the American Recovery and Reinvestment Plan are mainly opposed to one of two things: tax cuts added to garner Republican votes or too much spending that could lead to a greater deficit. But no matter what compromises he makes in order to engender support, President Obama should not hold out for universal popularity, in either the Democratic or Republican parties.