Deflation creeps up on Japan

TOKYO (Reuters) - Japan is bracing for another spell of deflation next year, but chances are price declines will be less protracted and damaging than the last, decade-long run.

Falling prices may be good for consumers, but if the declines persist they discourage spending -- why buy anything now if one can get it cheaper later? That cripples investment and triggers a vicious spiral of falling prices and economic stagnation.

For most nations deflation has been a bogey-man confined to economic textbooks, but in Japan declining consumer prices and weak growth have been a fact of life for much of the past decade.

Soaring oil and food costs helped push prices higher in the past year or so, but analysts say the retreat in commodities markets and a recession in Japan and much of the developed world mean consumer prices are set to start falling again next year.

"You can't underestimate the chance of prices falling again in Japan," said Hideo Kumano, chief economist at Dai-ichi Life Research Institute.

"It will likely happen next year, just when domestic demand will suffer more from the lagging effect of the global slowdown."

The Organization for Economic Cooperation and Development, a think tank for rich nations, also forecasts deflation to set in Japan next year and says its group of 30 members appears to have entered a recession.

Even during the commodity price flare-up earlier this year soft demand made it hard for Japanese companies to pass on higher costs to consumers.

Headline inflation peaked at a decade high of just 2.4 percent in July and August, well below the euro zone and United States -- and Japanese wholesale inflation that hit a 27-year high of 7.4 percent in August.

SHALLOW SLUMP

Economists are optimistic, however, that the world's second-largest economy is in a better shape than at the beginning of this decade and has a chance to bounce back to economic growth and rising prices much quicker now.

"Japan may fall into deflation next year but I think it will be temporary," said Azusa Kato, an economist at BNP Paribas.

"That's because Japan's economic slump still looks shallower than around 2002 when it was last in recession with jobless rate topping 5 percent and the economy's supply exceeding demand far greater than now," she said.

Back then, the Bank of Japan kept flooding the banking system with excess cash for five years to halt price falls that persisted over the 1998-2006 period and the economy's slide in the wake of the 2001 dot.com bust.

This time, the central bank is unlikely to resume so-called quantitative easing as banks are much healthier than in the early 2000s when they were saddled with huge bad loans, analysts say.

But they say worrying signs of economic weakness still abound and the central bank will have to act resolutely to limit the damage.

The BOJ joined other central banks across the globe in rate cuts last month, trimming interest rates to 0.3 percent from 0.5 percent to avert a deepening of the global credit crisis.

MORE CUTS?

It kept rates steady on Friday and BOJ Governor Masaaki Shirakawa played down the likelihood of further cuts, saying they might cause problems in money markets, but some analysts say the central bank may have to trim rates further.

"Japan's exports and capital spending will further weaken from now on, putting downward pressures on domestic demand," said Yasuo Yamamoto, senior economist at Mizuho Research Institute.

"As the economy further worsens, the BOJ will cut interest rates in December at earliest and facilitate monetary easing."

Japan's economy shrank for a second straight quarter in July-September to follow the euro zone into recession.

And with companies cutting bonuses, freezing hiring and wages and some trimming prices already to woo customers, deflationary forces are already at work.

"We're cutting prices to support consumers who are keeping their purse strings tight even as the year-end sales draw near." said an official at Wal-Mart Stores Inc's Japan unit, Seiyu Ltd, which has cut prices of 1,700 items by 5-30 percent.

But in a weak economy, falling prices feed expectations of more reductions ahead and Japan Research Institute expects core consumer prices to drop 1.2 percent in the next financial year to March, 2010. Dai-ichi Life Research expects a fall of 0.8 percent in the same year.

Several economists expect core inflation to turn positive again in the 2010/2011 fiscal year, but some say the Bank of Japan must act aggressively to make it happen.

"A central bank must nip such a deflationary spiral in the bud even if it's still considered unlikely now," said Naomi Hasegawa, senior fixed income strategist at Mitsubishi UFJ Securities.

"I wouldn't be surprised if the BOJ cut interest rates to 0.10 percent in March or April and take steps toward further easing, if not a return to quantitative easing."

(Editing by Tomasz Janowski)