Deflation is defined as a contraction of money supply. So when Fed Chairman Ben Bernake basically increased the money supply through quantitative easing last year, many thought that we would go through some more inflation. Yet the opposite is happening. How could that be. See most of the money supply in the world is in the form of IOU's. When a bank produces a loan, currency is created. Why? Because of fractional reserve banking. When a bank gives out a loan, the bank does not actually have most of the currency in the bank to back up that loan. No, the currency is created out of thin air because of the banking laws in the United States says that the banks do not actually have to have 100% of the money in the bank in order to loan it.
But because of the real estate market tumble and poor US economy, banks are not giving out as many loans and they are defaulting on more loans. The combination of these two factors has led to a contraction of the money supply. People are simply taking out less loans or paying off the loans they have. No matter what the Fed does, the money supply is going to contract because people have no desire to take out more loans.
The Fed hates deflation, because in a deflationary environment prices and income go down yet debt stays the same. This is disastourous, because how can they pay down their debt with less income coming in.
I worry that with this deflation, the Fed will overreact by printing out a vast amount of currency. When governments print out too much currency to meet their debt obligations, history shows that the government could go into high inflation or even a currency destroying hyper-inflation.