Japan Logs Record Deflation as Demand Falls

Japanese consumer prices fell a record 1.1. percent in the year to May, with falling demand increasingly blamed as the country's second bout of deflation in less than two years deepens.

The slide may make the Bank of Japan less willing to end  unconventional policies due to expire in September, analysts say.

"Deflation is getting worse and underscores that the BOJ cannot move for a considerable time," said JP Morgan senior economist Masamichi Adachi. "Even with deflation going further, as long as the real economy is on an uptrend, I think the BOJ will not activate quantitive easing."

Finance minister Kaoru Yosano also expressed concern about the impact of falling output and demand as the nationwide core consumer price index fell 1.1 percent in May from a year earlier.

It was the largest fall in records dating back to 1970 but slightly less than a consensus forecast for a 1.2 percent decline. 

Falling energy costs were the main culprit for the decline, but analysts expect price falls to accelerate in coming months as slack household consumption also forces companies to cut prices.

The so-called core-core inflation index, which strips out both energy and food prices and is similar to the core index used in many other developed countries, fell 0.5 percent from a year earlier.

"I'd say about half of the fall in the core-core index is driven by weakness in demand. The fact that the prices of general services posted a year-on-year fall in May also highlights soft consumer demand," said Junko Nishioka, chief economist at RBS Securities.

Consumer inflation in Japan has retreated from a decade high 2.4 percent last summer, largely in reaction to the previous year's sharp rises in oil and other commodities costs.

But prices also fell due to weak demand as Japan suffers its worst recession since World War Two.

"We expect pressure on prices from weak domestic demand to strengthen and to peak around the year-end," Nishioka said.

Yosano said the price falls were likely due to declines in output and demand, adding that the government would implement economic policy in a way that prevents Japan from falling into a deflationary spiral.

Consumer prices for Tokyo, available a month before the nationwide data, fell 1.3 percent in June from a year earlier, more than a median market forecast of a 1.1 percent decline.

The central bank is already forecasting two years of deflation so price falls alone are unlikely to nudge it into returning to quantitative easing, a policy of flooding markets with excess cash. It is already buying large quantities of government bonds.

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The BOJ currently forecasts Japan's core CPI to fall 1.5 percent in the year to March 2010 and to decline 1.0 percent in fiscal 2010/11.

Expectations that the world's no. 2 economy will start growing again after four straight quarters of contraction have prompted speculation that the BOJ may think about phasing out emergency steps introduced in the midst of the global financial turmoil to support corporate finance.

But the Organisation for Economic Co-operation and Development made clear that ending the BOJ's unconventional measures, such as buying commercial paper and corporate debt from banks, any time soon would be premature and recommended maintaining "effective quantitative measures" until inflation returns.

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