Understanding Deflation

The term “inflation” is something that we commonly hear in the news. We often hear of the woes it creates. But did you know that there is something that is actually worse than inflation? “Deflation” is not something we frequently hear about but it is something we should all be concerned with, particularly if we are in the market for a new house.

What is Deflation?

Deflation is a decrease in the general price level of goods and services over time. In fact, deflation is the opposite of inflation. When the inflation rate is negative, the economy is experiencing a deflationary period. Deflation often has the side effect of increasing unemployment and other economic woes in an economy, since the process often leads to a lower level of demand in the economy.

What Causes Deflation?

While the concept of deflation can seem rather complicated, when broken down, deflation occurs as a direct result of one or more of the following four factors:

• The supply of money goes down
• The supply of other goods goes up
• Demand for money goes up
• Demand for other goods goes down

Deflation usually occurs when the supply of goods rises faster than the supply of money. This is consistent with these four factors mentioned above. These factors clarify why the price of some goods increase over time while others decline.

Deflation is a result of complex economic forces. Ultimately, deflation is a result of the reduction in the supply of money or credit. It is can also be caused by direct contractions in spending, either in the form of a reduction in government spending, personal spending, or investment spending.

Why Deflation is Worse Than Inflation

Since deflation is partly triggered by prices decreasing due to a lack of demand, it might initially seem like a good thing. However, when the price of everything falls it can harm everybody and the economy as a whole.

Falling prices means lower revenue and profit margins for companies. This leads to layoffs, less hiring, stagnant wages, and outright pay cuts. The consumers with lower incomes have less money to spend. This starts a vicious cycle of: sales being down and cutting prices to get more business. Once this occurs, everybody realizes that prices are falling and nobody wants to buy something today if it will be cheaper tomorrow. As a result, they stop spending even more. Thus, a vicious cycle becomes even worse.

Inflation, in moderation, is a natural part of a healthy economy. It can actually ease the burden of debt over time because the real value of fixed debt goes down. Deflation wreaks havoc with this normal economic cycle and causes even more problems. It’s almost as if the cycle of supply and demand goes in reverse.

The complexity of dangers deflation presents run deep. One risk comes from a rush to keep interest rates low to increase consumer spending. Initially this might seem like a foolproof method to curb deflation. However, this creates even more problems.

One such problem is called “hyperinflation.” The danger of hyperinflation lies in a dramatic increase in the velocity of money due to a loss of confidence. In this case, money increases in value so rapidly that the currency actually loses its value. This problem would usher in new and even possibly worse problems than the deflation that triggered it.

What Deflation Does to Mortgages

Deflation can have a negative impact on your mortgage. It can actually increase the burden of your mortgage debt over time. In the normal life span of a mortgage, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive. Over time, it increases the disposable income of mortgage owners.

However, with deflation, your mortgage payment becomes a larger percentage of your disposable income. Debt becomes an increasing burden, reducing spending and economic growth.

Economic problems can vary greatly and create more complex problems over time. Deflation, the opposite of inflation, creates an economic condition that devalues money over time. It can be a tricky event to reverse as other problems like hyperinflation threaten to have a strong backlash that creates even worse problems.

These economic conditions can all have a direct impact on your mortgage. By staying on top of current economic trends, you will be in a much position to understand how the current economy is directly impacting you and your mortgage.