Japan's Government Confirms Deflation

By TOMOYUKI TACHIKAWA

TOKYO -- Japan's government Friday officially declared the economy has fallen into deflation and cautioned that continuous price declines could spell trouble for the economy's nascent recovery.

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Japan's Deputy Prime Minister Naoto Kan arrives at a lower house plenary session at Parliament in Tokyo September 18, 2009.

Weak domestic demand has caused the world's second largest economy to enter "a mild deflationary phase", the government said in its November monthly economic report released Friday.

This is the first time since mid-2006 that the authorities said Japan is beset by persistent price falls, which can hurt the economy by pushing down corporate profits, increasing firms' debt burdens, and prompting company managers to reduce workforce and hold off on new investments. The declaration in its official report suggests Tokyo is worried about whether the price downturn will lead to a double-dip recession.

The government also said it needs to watch whether the economy is depressed by a further worsening of the jobs market, concern over a slowdown in overseas economies, and damage from deflation and volatility in markets.

As for the overall economy, the government left unchanged for the second month its view that while the economy is picking up, the recovery isn't primarily being driven by domestic factors, and that worrisome factors such as a relatively high unemployment rate remain.

Prices in Japan have been falling for much of this year, but signs have emerged recently that deflation might be worsening due to the weak economy. Gross domestic product data released on Monday showed that one indicator of local prices, the domestic demand deflator, fell at its fastest pace in more than 50 years in the July-September period. If prices continue to fall, risking a worsening of the economic slump, that might result in the government putting more pressure on the Bank of Japan to further ease its monetary policy.

The government report said only that Tokyo "expects the Bank of Japan to conduct appropriate and flexible monetary policy," working closely with the government to ensure the economy gets back on a growth path with stable prices.

Prior to the release of the economic report, Deputy Prime Minister Naoto Kan said "the government would covey its views on deflation to the BOJ. There may be a lot to be done on the monetary (side)" in resolving the issue. The central bank concluded its two-day policy board meeting Friday. Government representatives attend those meetings.

For its part, the BOJ has committed itself to "patiently" keeping extremely easy monetary conditions in place, and it expects that domestic consumer prices will keep falling at least for the next two years.

But the central bank last month decided to terminate part of its special corporate finance-support measures, and reiterated that price falls are unlikely to induce downward pressure on economic activity, while the possibility of Japan hitting the double-bottom seems small.

Some government officials have criticized the BOJ's economic views as too optimistic and called on the bank to play a more active role in bolstering the still-fragile economy.

To prop up domestic demand, Tokyo is planning to spend Y2.7 trillion in a second extra budget for the current fiscal year ending March.

If the spending amount increases and fears grow that the new administration might boost public spending to such an extent that it worsens Japan's fiscal health, the central bank might be forced to purchase more government bonds to help curb long-term interest rates, some analysts said.

Write to Tomoyuki Tachikawa at tomoyuki.tachikawa@dowjones.com