Japan’s Deflation Concern Mounts Even as Growth Accelerates

By Jason Clenfield and Tatsuo Ito

Nov. 17 (Bloomberg) -- The acceleration of Japan’s economy to the fastest growth pace in more than two years masked a slide in prices of goods and services that threatens to temper the nation’s recovery.

The domestic demand deflator, a measure of price levels that excludes the cost of imports, fell 2.6 percent in the third quarter from a year earlier, the most since 1958, Cabinet Office figures showed yesterday in Tokyo. At the same time, gross domestic product jumped 4.8 percent, the most since early 2007.

Sustained price declines threaten to curtail a corporate- profit rebound that’s already been insufficient to spur a rally in Japan’s shares this quarter. The report prompted Deputy Prime Minister Naoto Kan to say the government may outline an emergency-spending package as soon as today, adding that “I’m concerned we’re entering into a deflationary situation.”

“This isn’t sustainable growth and the government knows it -- that’s precisely why they’re talking about the GDP deflator,” said Junko Nishioka, chief economist at RBS Securities Japan Ltd. in Tokyo. “On the face of it, 4.8 percent growth is a positive for the Democrats, but they’re not reading it as a reason to abandon their economic policies.”

Most stocks dropped yesterday, with the Topix closing at 860.42 at 3 p.m. in Tokyo, the lowest level since July 13. While the Nikkei 225 Stock Average rose 0.2 percent to 9,791.18, about four stocks retreated for every three that climbed.

Pushing BOJ

Kan also said yesterday that the government should work with the Bank of Japan to tackle the price slump. The central bank has kept interest rates near zero to help rekindle growth.

Consumer prices in the world’s second-largest economy have fallen for seven straight months, undermined by the deepest recession in the postwar era.

Deflation can undermine the economy by persuading companies and consumers to delay purchases in the anticipation of further price declines. It also increases the value of their debt.

“Deflation is great if you don’t have debt,” Nishioka said. “But debt drives most economic activity. Companies take out a loan to build factories or you get a mortgage to buy a house. Those burdens get heavier when incomes start to fall.”

The yen’s 6 percent gain against the dollar in the past three months has exacerbated the price slump by making imports cheaper.

Even after seven months of gains in factory output, about one third of Japan’s factories sit idle. The Democratic Party of Japan took power in September pledging to support households that have endured 16 months of wage declines and unemployment that climbed to a record in July.

‘Biggest Worry’

“The biggest worry to us is that consumption growth has been too strong relative to incomes,” said Hiromichi Shirakawa, chief Japan economist at Credit Suisse Group AG in Tokyo, who used to work at the central bank.

“It might be a decade before the job market returns to the level of health we had a year or two ago,” he said. “The number of jobs may recover but not wages. It’s very fragile.”

A price war over jeans is a sign of that fragility. Discount retailer Don Quijote Co. last month started selling jeans for 690 yen ($7.70), undercutting Aeon Co., Japan’s largest supermarket chain, which has been offering them for about $9. Fast Retailing Co., the operator of Uniqlo stores, started the battle in March with pairs at $11.

“Japanese domestic demand is still dependent on price declines to grow,” said Naomi Fink, a strategist at Bank of Tokyo-Mitsubishi UFJ Ltd.

Contraction Continues

Without adjusting for prices, Japan’s economy shrank an annualized 0.3 percent last quarter, the sixth straight contraction. The Democratic Party of Japan has signaled that these nominal figures will play a greater role in its policy making.

“There’s been a tendency to focus on the price-adjusted figures,” Keisuke Tsumura, one of the DPJ’s top economic officials, said in an interview this month. “We’re going to try to strike a better balance in our decision-making that doesn’t ignore the nominal figures,” which he said better reflect the economy as households experience it.

The government’s heightened concern about deflation may put it at odds with the Bank of Japan. While the central bank last month forecast prices will keep falling through the year ending March 2012, Governor Masaaki Shirakawa has said deflation is unlikely to weigh on economic growth.

The central bank won’t have room to raise the benchmark interest rate from the current 0.1 percent until at least the end of 2010, according to 15 of 16 analysts surveyed by Bloomberg News last month.

Double Dip

Still, most analysts said yesterday’s report suggests Japan will avoid a double-dip recession. Domestic demand, which includes consumer spending and business investment, contributed two-thirds of the country’s growth last quarter. In the previous three months, exports led the economy’s first expansion in more than a year.

“The composition of these numbers was a lot more encouraging than the second-quarter numbers, said Richard Jerram, chief economist at Macquarie Securities Ltd. in Tokyo. “It wasn’t the net exports story, it was a swing in private domestic demand, which brings some promise of greater stability.”

To contact the reporters on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net; Tatsuo Ito in Tokyo at tito2@bloomberg.net

Last Updated: November 16, 2009 10:01 EST