A gallon of gas in my neighborhood peaked in mid July at $4.96. Yesterday, the same gas at the same station could be had for $1.84 a gallon ... 63% deflation in a matter of months! Earlier this summer, Steven Colbert joked that, "When I first started paying $4 a gallon for gas, I didn't mind. I thought I was just getting better gas." Let's hope the same theory doesn't work in reverse.

All of this deflation might seem completely backwards at first. Now that Uncle Sam has thrown some $8.6 trillion at the financial fiasco, you'd expect inflation, if not Zimbabwe-esque hyperinflation, to rule the economy, right?

Print now or forever hold your peace
Sort of. Inflation isn't simply the result of the Fed printing money; it's also a function of how fast consumers turn around and spend that money -- called money velocity. Without any velocity, the Fed can create money like no one's business, but inflation won't budge (at least for now ... keep reading.) Think of it this way: You can make as many bullets as you want, but those bullets don't do any damage until they're actually fired.

A good example is Japan in the '90s. In a desperate attempt to pump life into the economy, Japan nearly tripled its money supply over the course of a decade. Did it lead to crippling inflation? Nah. Check out this chart -- Japan struggled to keep prices treading water for years. Why? Check out the blue line in this chart -- the velocity of money fell off a cliff. There were more factors involved here, but Japan's a good example of an explosion in the money supply that didn't come close to inflation.

The reason countries like Zimbabwe get destroyed by hyperinflation isn't just because the government runs the printing presses at full-bore, but because the urge to spend that money is out of this world. There are stories of Zimbabweans prepaying their restaurant bills because the price would surge in the time it took to eat. When you get a situation like that, anyone in their right mind will get rid of (spend) their money as quickly as possible -- likely within hours of getting it. In other words, the velocity of money is off the charts.

So what are we -- Japan or Zimbabwe? Maybe Japabwe?
Right now, the velocity of money in the U.S. is plunging because we're deleveraging like there's no tomorrow. What little money people have is going to either mending debts or saving in anticipation of a dismal future. Even oil companies like ExxonMobil (NYSE:XOM), ConocoPhillips (NYSE:COP), and Chevron (NYSE:CVX) are facing the reality of cash conservation.  

That's why it's deflation, not inflation or hyperinflation, that's taking control these days. We can keep the printing presses rollin' 24 hours a day, but it won't become inflationary in the short term simply because no one's willing or able to spend it (more specifically, banks like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) aren't dumb enough to lend it out to people they know aren't able to pay them back). More importantly, the Fed can pull monetary liquidity out of the banking system before money velocity picks back up, extinguishing an inflationary bedlam before it becomes a problem … at least in perfect world.

Now for the other side of the coin
The big questions are what happens when (a) consumers pull out of the fetal position and start spending while the Fed is asleep at the wheel (cough … Alan Greenspan … cough, cough) and (b) what happens when foreigners finally realize that greenbacks are really just pieces of paper and stop buying Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) securities and Treasury notes, spawning a fire sale of the dollar.

Many economics textbooks mention inflation with a disclaimer of "assume a closed economy," which is essentially asking you to believe we're a self-sufficient economy that doesn't borrow a dime from the rest of the world.

Of course, it's malarkey. As a country hellbent on spending more than we make, the inflationary forces that'll dictate the future rely on the hope that foreign investors will believe we're the world's alpha economy. The major difference between our current situation and Japan's in the '90s is that Japan didn't rely on the world's willingness to fund its indulgences.

Where we go from here
My guess is that the future threat of inflation will be a balance between the two forces:

  1. The Fed raising interest rates and reigning in the money supply before money velocity awakens from hibernation.
  2. A gradual loss of confidence by foreign investors that undermines a lot of what the Fed can combat.

Bottom line: There's no way around a weaker dollar and a hefty dose of inflation in the future. But weigh the two above forces together, and I'm loath to think it'll be as meteoric as hyperinflationist goldbugs like to dream about. There are balancing forces on each side of the equation. On one end, you can't just look at the current money supply and pin down the prospects of future inflation without considering that the Fed can pull liquidity out of the banking system before money velocity picks up. On the other hand, you can't get too comfortable with the prospect of lingering deflation simply because we're beholden to a global financial system that'll eventually lose its appetite of paying for our mistakes.

For related Foolishness and ideas on how to battle the forces of inflation:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Bank of America is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.