Japan returns to deflation brink
By Kosuke Takahashi
TOKYO - The impact of the global slowdown on Japan's exports is raising fears
that the world's second-largest economy faces a return to the debilitating
effects of the deflation that hamstrung the economy after the collapse of an
asset bubble economy in the early 1990s.
Japan's economy slipped into recession in the last quarter for the first time
in seven years. Declining demand at home combined with an inflow of cheaper
goods from abroad triggered by the recent rapid appreciation of the yen, could
drive down prices into the feared deflationary spiral.
To make matters worse, possible deflation may be accompanied
by weaker domestic demand arising from long-term demographic trends, as a low
birth-rate leads to an ageing population and workforce. The labor force of
about 66 million people aged 15 or over as of 2006 will decline by more than 10
million by 2030, according to the Health, Labor and Welfare Ministry.
"Japan's economy is like to slip into deflation by the middle of 2009 as core
consumer prices turn negative," said Kazuo Mizuno, chief economist in Tokyo at
Mitsubishi UFJ Securities Co, a unit of Japan's largest publicly traded lender
by assets. "Looking ahead, Japan is vulnerable to deflation risks, at a time
when the labor force continues to be shrinking because of the falling birthrate
and the aging population, pushing down domestic demand."
A decline in inflationary pressures is already evident, with consumer prices,
excluding fresh food, rising only 1.9% in October after gaining 2.3% in
September. The Bank of Japan on November 25 released data showing that
corporate service prices fell for the first time in more than two years in
October because of falling oil and commodity prices. The corporate service
price index gauges the overall level of prices that companies pay for services.
Consumer prices, excluding fresh food, declined each year from fiscal 1998
through 2004, and in each of the next two years gained a mere 0.1%. By July,
fueled by rising commodity and energy prices, inflation reached a decade high
of 2.4%.
US Federal Reserve chairman Ben Bernanke, then a Fed governor, six years ago
highlighted the damage deflation can cause to an economy, not least in driving
up unemployment.
"Deflation is in almost all cases a side effect of a collapse of aggregate
demand - a drop in spending so severe that producers must cut prices on an
ongoing basis in order to find buyers. Likewise, the economic effects of a
deflationary episode, for the most part, are similar to those of any other
sharp decline in aggregate spending - namely, recession, rising unemployment,
and financial stress."
Around next summer, "the nationwide core inflation rate could turn at least
temporally negative from a year earlier, especially because this summer's rate
was very high," said Tomoko Fujii, head of economics and strategy for Japan at
Bank of America Corp. in Tokyo. She cited an increase in a negative output gap,
falling energy prices and a deterioration in the labor markets.
The Organization for Economic Cooperation and Development (OECD), a club of 30
wealthy nations, last week said deflation may return to Japan by the middle of
2009 and singled the nation out as facing the biggest threat of declining
prices. It specifically said consumer prices will drop 0.3% in the third
quarter of next year and 0.2% in the fourth, as growth contracts 0.1% in 2009
from the previous year.
"The OECD's forecast is for export-led contraction to drag domestic demand into
deflation," Naomi Fink, Japan strategist in Tokyo at Bank of Tokyo Mitsubishi
UFJ, wrote in a research note to clients on Friday. "Is the OECD's forecast
eerily prescient, or does it underestimate Japan's potential in the face of
greater deflationary pressures from overseas (rather than home-grown
deflation). October data did not look promising. Both household spending and
industrial production data out Friday posted unexpectedly large declines,
boding ill for final demand."
Slowing overseas growth and a stronger yen both contributed to the unexpected
scales of the declines. Japan posted a 63.9 billion yen (US$670 million) trade
deficit in October, the first deficit for the month in 28 years. Exports to the
rest of Asia declined for the first time since February 2002. A drop in
overseas demand for Japanese goods and services puts downward pressure on
Japan's domestic capital spending, employment and consumption.
The yen has advanced 18% against the US dollar this year and 36% against the
euro, as investors unwind the so-called yen carry trade, in which yen borrowed
at low interest is changed into other currencies and invested for higher yields
than the interest charged on the yen loan. The Japanese currency at present is
trading at about 94.80 to the US dollar.
Indicating the deflationary pressure on the economy, Japan's output gap, a
measure of the economy's supply and demand balance, remained negative for a
second quarter in July-September, widening to minus 0.8% , its most negative
reading in three years.
The government is aware of the dangers presented by the global slowdown, with
Economic and Fiscal Policy Minister Kaoru Yosano telling a press conference in
Tokyo on Friday that they would likely have a deflationary impact on Japan. He
did not indicate what steps would be taken to limit that impact.
The Bank of Japan will be forced to lower its key interest rate to zero percent
and adopt what is known as quantitative easing, which means pumping staggering
amounts of liquidity into the economy, mirroring actions taken between 1999 and
2006 - according to Mitsubishi UFJ Securities' Mizuno and other economists.
"Still, the effectiveness of interest rate cuts and quantitative easing are
very questionable," said Mizuno. "Those policy measures are losing
effectiveness."
Bernanke in his 2002 speech pointed out that in times of deflation the
financial distress of debtors can, in turn, increase the fragility of the
nation's financial system - for example, by leading to a rapid increase in the
share of bank loans that are delinquent or in default. The zero bound on the
nominal interest rate raises another concern in that it limits the conventional
monetary policy. These limits constrained the Japanese economy until July 2006,
when the Bank of Japan lifted its key rate from zero percent to 0.25%.
The central bank will cut rates to 0.10% in February, following the 0.2%
reduction in October, said Bank of America's Fujii. The benchmark interest rate
at present stands at 0.3% , the lowest among major industrialized countries.
Central bankers around the world are cutting interest rates to prevent global
market mayhem from degenerating into a cycle of deflation and recession. Former
Bank of Japan governor Toshihiko Fukui at the weekend expressed alarm at
Japan's possibly returning to a quantitative easing policy.
"With financial borders becoming lower, it cannot be avoidable that Japan will
have been affected more or less" by movements on the world stage, said Fukui,
who views the central bank's zero-interest-rate policy and the quantitative
easing policy as an abnormal state of the monetary policy.
Kosuke Takahashi is a Tokyo-based journalist. He can be contacted at
letters@kosuke.net
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