Slow growth may push Japan back into deflation: OECD

TOKYO (Reuters) - The OECD has singled out Japan as facing the biggest threat of deflation among industrialized nations next year, warning that the global financial crisis could further damage an economy already in recession.

The prices of Japanese business services fell by the largest amount in five years in the year to October due to a slump in freight costs, fuelling concerns that the world's second-largest economy may return to deflation later next year.

Central bankers, who just a few months ago were struggling to contain an inflation flare-up stoked by soaring commodity prices, are now trying to prevent global market mayhem from degenerating into a cycle of deflation and recession.

The Organisation for Economic Cooperation and Development forecast that Japan -- which faces falling exports, weakening the growth outlook, and sliding prices for commodity imports -- could see deflation of 0.3 percent for the year to the third quarter next year.

"The exceptional uncertainty about the world economy poses a number of risks," such as the possibility of the global financial crisis disrupting Japan's financial sector, the OECD, a think tank for rich nations, said in a report.

"There is also a risk that slower growth would push Japan back into deflation."

In a sign of mounting problems for Japan, the central bank cut its assessment on exports and output on Tuesday, saying they were decreasing.

Consumer demand is plummeting across the industrialized world as commodity prices tumble, with U.S. consumer prices falling at a record pace in October.

Japan's corporate services price index (CSPI), which tracks prices of business-to-business services, fell 1.4 percent in October from a year earlier, Bank of Japan data showed.

DEFLATION NO SURPRISE?

The deflationary outlook from the OECD will come as no surprise to some economists.

"In terms of business-to-business service transactions, we're already seeing signs of a deflationary trend," Kyohei Morita, chief economist at Barclays Capital Japan, said ahead of the OECD report.

"The Japanese economy seems to be moving closer toward our scenario, which is for it to experience deflation around the third quarter of next year."

While the fall was mostly due to declines in overseas freight costs, some analysts said Japanese companies were cutting back on other costs such as software development and advertising as the economy slips into recession.

The Bank of Japan has said it expects inflation to moderate but it did not forecast a return to deflation, which afflicted Japan for about a decade from the 1990s.

It forecasts core consumer inflation of 1.6 percent in the fiscal year to next March 31, followed by zero percent growth in the following year.

But economists say Japan could teeter on the verge of deflation in the next fiscal year. Economists polled by Reuters expect core consumer prices to show a fall of 0.5 percent as early as the third quarter next year.

A weak economy may also push down prices, some analysts warn, with Japan's economy having slipped into recession in the third quarter for the first time in seven years.

OUTPUT GAP GROWS

Underscoring the looming risk of price declines, Japan's output gap, a measure of the economy's supply and demand balance, widened to its most negative reading in three years in the third quarter.

A negative output gap means supply exceeds demand in the economy, which in theory reduces inflationary pressure.

In its monthly report for November, the Bank of Japan said declines in production were expected to accelerate in the near term as exports were seen declining on slowing overseas growth and a stronger yen.

"Economic activity will remain increasingly sluggish over the next several quarters as the slowdown in overseas economies becomes more evident," the central bank said.

The Bank of Japan also warned that the nation's financial conditions have become less accommodative as a whole, with an increasing number of big companies facing worsening funding conditions in markets.

Data due out on Friday is expected to show Japan's annual core consumer inflation slowed to 1.9 percent in October from 2.3 percent in September due mainly to falling oil prices, a separate Reuters poll showed.

(Additional reporting by Yuzo Saeki, Yasuhiko Seki; Editing by Hugh Lawson)