Deflation Signs Spur Fears of a Drag on Japan's Recovery

TOKYO -- As the world resumes economic growth after the steep global downturn, a familiar problem may keep Japan from following: deflation.

Economists expect the Bank of Japan in its semiannual outlook Friday to forecast that the core consumer-price index will fall for the fiscal year ending in March 2012, at a rate of at least 0.5%. That represents three years of expected deflation. The central bank has projected a decline of 1.5% for the current fiscal year and 1% for the next.

Economists see little immediate risk of Japan entering a deflationary spiral, in which price declines accelerate as demand drops and economic activity ebbs. An extended period of deflation can keep consumers from spending and companies from investing as they wait for prices to fall further.

"We are very concerned about deflation being a drag on [Japan's] economic growth," said Randall Jones, an economist heading research on Japan and South Korea at the Organization for Economic Cooperation and Development. He urged the BOJ to keep its policy rate close to zero and "focus on trying to stop deflation."

Japan's core CPI fell for six straight months, on a year-to-year basis, ending with a record 2.4% decline in August. A similar decline is projected for September, though the size of the declines are projected to narrow afterward, reflecting changes in energy prices. Excluding both food and energy, Japan's CPI fell 0.9% in August from a year earlier.

Though Japan remains expensive, signs of deflation can be found throughout the economy. Workers' cash earnings fell 2.7% in August from a year ago. Year-end bonuses paid by 218 large companies listed on the Tokyo Stock Exchange will fall 13.1% this year, the largest drop at least since 1970, according to a survey by the Institute of Labor Administration.

"The continued drops in income are making households more thrifty," says Ryutaro Kono, an economist for BNP Paribas Securities in Tokyo. "Companies are responding by cutting prices, sensing they wouldn't survive otherwise."

In the fashion industry, Uniqlo, Fast Retailing Co.'s casual-clothing brand, ignited a price war this year, introducing a new line of jeans for 990 yen ($10.80) a pair. Soon, Seiyu Ltd., a Wal-Mart Stores Inc. unit, cut its price to 850 yen, followed by Don Quijote Co., a discount chain, with a 690-yen price tag this month.

Food prices are declining. Desperate to spur sales, supermarket and convenience chains are replacing national-brand products with cheaper private-brand options, offering smaller packages and turning their stores into shops that advertise most items at 100 yen.

"Of course, I compare prices because I am a housewife," says Shizuko Shibata, a 74-year-old pensioner who lives with her daughter in Setagaya, a Tokyo residential area. Ms. Shibata had just come out of a new 100-yen supermarket, where she bought a bag of frozen edamame, among other things. "I am not crazy about the quality at these stores, but these small packages are just the right size for us. "

Overall retail sales fell for the 13th straight month in September, with a 1.4% year-on-year drop.

There are some positive signs for Japan. On Thursday, Japan reported industrial output rose 1.4% in September, the seventh straight month of gains, as global stimulus spending supported demand.

When prices rose in 2006, Japanese policy makers had signaled that deflation appeared to be tamed. Much of that growth is now attributed to then-rising commodities prices.

The deflation can be blamed on Japan's long-term structural problems, including an aging population and one of the lowest birth rates in the developed world. Japan's new government has proposed an ambitious program of $185 billion in spending each year to spur consumption at home, though many economists say longer-term growth initiatives and economic overhauls are needed.

The BOJ is expected to forecast near-flat growth in gross domestic product for the fiscal year ending in March 2012. Previously, it forecast a growth rate of 1.2% for fiscal 2011 after a 3.2% decline this fiscal year.

"Expectations for long deflation may be making companies more cautious about their capital-investment plans," says Junko Nishioka, a RBS Securities economist in Tokyo.

Deflation can benefit consumers and companies by making goods and services more affordable. But it also hurts people with debts—whether an individual with a home mortgage or a nation with a fiscal deficit—by inflating the value of their debts in real terms.

Write to Yuka Hayashi at yuka.hayashi@wsj.com