What is deflation and is it good or bad for the UK economy?

Britain is officially in deflation for the first time since records began, the Office for National Statistics announced on 19 May.

What is deflation?

It is a reduction in the prices of goods and services. While it might mean good news for consumers, if it continues, deflation could become problematic for the country's overall economic health.

The theory goes that because goods get cheaper, people hold off making purchases in anticipation of further reductions. Businesses as a result have less trade and are forced to lower prices further. These firms then have to make up for it by cost-cutting, usually through making redundancies.

Those people who are laid off are no longer able to buy goods or services, meaning even less consumer activity. This, economists say, is a deflationary spiral or, in layman's terms, "bad deflation". This is something Japan went through for more than two decades beginning in the 1990s, despite the best efforts of policymakers to reverse it. Fortunately, Britain is not in this kind of spiral, nor is it likely to be. Instead, what we have in the UK is something called "good deflation".

Good deflation

Mark Taylor, a former Bank of England and economist and dean of Warwick Business School, reveals what this means. "This kind of deflation is not bad for the economy because it's coming from the supply side – weak energy and food prices – rather than any fundamental weakness in the demand side or consumer spending," he said.

Low oil prices and a bitter supermarket price war have driven prices down in these sectors, rather than a fall in consumption. Not only is this expected to change soon, with oil prices on the rise and supermarkets forecast to decelerate price cuts, but employment, average earnings and consumer spending are all on an upward curve.

In fact, Philip Shaw at asset management group Investec argues Britain is not technically in deflation yet.

"We prefer to classify this as 'negative inflation', with deflation more strictly defined as a period of falling prices that are both sustained and general (not restrained to one or two sectors). Our own view is that this negative April print will not turn into a sustained run," he said.

Chancellor George Osborne agreed, saying: "We should not mistake this for damaging deflation. We have to remain vigilant to deflationary risks and our system is well equipped to deal with them should they arise."

More bad news for savers

Interest rates have been held at the historic low of 0.5% since March 2009 and savers have been waiting for them to go up ever since. But economists believe these figures will mean the Bank of England holding off raising them.

Howard Archer, chief economist at research think tank IHS Global Insight, said: "Deflation of 0.1% in April reinforces belief that the Bank of England will most likely hold off from raising interest rates until the second quarter of 2016."