Deflation hits Japan ... again

The economy may be growing and consumers more confident, but prices are on the way down once more.

It's official. After months of avoiding the issue, Japan's government yesterday admitted that deflation is once again casting its long shadow over the land of the rising sun.

The monthly report from Tokyo's Ministry of Finance is blunt in its assessment. "Recent price developments show that the Japanese economy is in a mild deflationary phase," it says starkly, before calling on the Bank of Japan to implement "appropriate and flexible monetary policy" to help fix the problem.

Deflation is an emotive subject in a country that only recently clawed its way out of the last so-called "lost decade" of stagnation which followed the 1989 asset bubble collapse. A degree of deflation is no surprise following a period of recession: a newly contracted economy leaves a surplus of supply, pushing down prices. The danger for Japan is that its 10-year history of deflation creates a psychological expectation that in turn leads to a self-fulfilling – and highly destructive – deflationary spiral. An even greater worry is what will happen when fiscal stimulus measures run out next year and the current uplift in economies around the world begins to flatten out.

In that concern, Japan is not alone, and the most bearish see a threat of widespread deflation. The UK, for example, has a 10 to 15 per cent probability of economic stagnation, according to estimates from BNP Paribas. Alan Clarke, an economist at the bank, said: "There is a risk of the UK, eurozone and US economies becoming the next Japan. There is lots of spare capacity, and until these economies have grown enough to close the gap there will be downward pressure on prices."

In Japan, it is already happening. As Tokyo admitted yesterday, deflation has haunted the country since the spring and is now worsening faster even than in the years after the bursting of the 1989 asset bubble. Core CPI – which excludes fresh food – was running at minus 0.1 per cent in March. By June it was minus 1.7 per cent. Now it is between minus 2.2 and minus 2.4 per cent. But CPI is not all there is, and real deflation is typically taken to include falls in the nominal value of all kinds of assets, not just consumer prices.

The picture is not wholly bleak. Japan is well out of recession, and has now registered two quarters of GDP growth – with this week's third-quarter 1.2 per cent growth figure beating expectations. Exports have been doing particularly well, thanks to the upswing in Asian growth, especially in nearby China. Add in falling unemployment rates and it is easy to explain the increase in consumer confidence that more bullish commentators say is worth any number of official statistics. Julian Jessop, chief international economist at Capital Economics, said: "Throughout the latest burst of deflation, ordinary Japanese people have still expected inflation to remain positive, and that is more important than any numbers."

But the spectre of unavoidable fiscal tightening looms large and Japan already has its share of negative numbers within the GDP headlines. Wages, land and property prices are all falling. The Nikkei and Topix are both underperforming. And although corporate profits are improving thanks to rising exports, there is so much excess capacity in the economy that they are not translating into investment. Adam Slater, a senior economist at Oxford Economics, said: "If the world economy continues to recover, then capacity utilisation will go up, profits will rise, investment will re-start and there will be growth. But the big questions are how long that will take, and if it will relapse when public-sector incentive schemes come to an end."

The issue of how to smooth the withdrawal of fiscal stimulae is crucial to the timing of the Japanese government statement on deflation. So far, the authorities' response to the recession has been overwhelmingly fiscal. The string of government-funded incentive schemes will add up to around 2.4 per cent of GDP this year – far higher than the G7 average. Meanwhile, monetary policy responses have been muted.

Since August 2008, the UK has increased its monetary base by 144 per cent of GDP through the quantitative easing programme. In the US, the monetary base has grown by 137 per cent, in the eurozone by 20 per cent. In Japan, meanwhile, it has grown by just 5 per cent.

The problem for Tokyo is that it cannot afford much more fiscal intervention. The budget deficit is set to rise above 10 per cent of GDP within months, and the debt-to-GDP ratio is expected to breach the 200 per cent mark by 2012 – the highest level in the industrialised world. What Tokyo wants from its central bank is a more active monetary policy, because it can do little more itself.