Slow growth may push Japan back into deflation: OECD

By Leika Kihara

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.