The green shoots of a recovery in Japan's manufacturing sector are appearing just as a protracted period of deflation menaces the nation's overall economy.
After three years of mild price increases, Japan is about to enter another stretch of deflation -- when constantly weakening prices discourage consumers from spending and companies from investing. In recent months, prices have been pulled down by falling oil and commodities prices as well as eroding consumer demand as Japan grapples with recession.
The encouraging news about manufacturing was accompanied by a grim diagnosis for the overall economy. The Bank of Japan lowered its forecast for the core consumer-price index, which excludes volatile fresh food but includes energy prices, to a decline of 1.5% for the current fiscal year ending in March, compared with an increase of 1.2% for the past fiscal year. For the fiscal year ending in March 2011, the central bank predicts the index will fall 1%.
Until recently, consumer prices have held up surprisingly well, thanks to the effect of previous increases in energy and commodities prices. But now that such a boost is disappearing, the core consumer-price index in March, to be announced Friday, is likely to have contracted 0.2% from a year earlier, marking the first decline since September 2007, according to forecasts from economists.
Amid the world-wide slowdown, inflation pressure has subsided rapidly -- giving rise to deflation concerns -- as commodities prices decline and wages shrink. The International Monetary Fund sees headline inflation in advanced economies falling by an average 0.2% this year, before rising by 0.3% in 2010.
'Japan starts with significantly greater deflation risks than the United States or the euro area,' the IMF said in a recent report. 'Economic activity is very weak, and, apart from the energy-related spike in 2008, the inflation rate has not been much above zero for many years.'
Deflation is taking hold in Japan even as recent data indicate the worst may be over for the country's all-important manufacturing sector, where a slump in exports has led to stark cuts in production. The government said Thursday that industrial production expanded 1.6% from a month earlier in March, in its first increase in six months. Output remains far lower than year-earlier levels but the data suggest manufacturers are beginning to ease up on production cuts as inventories that had piled up have slimmed down considerably.
The BOJ said the economy will likely contract 3.1% during the current fiscal year, before expanding 1.2% in the following year. The central bank kept its monetary policy steady, with its key rate near zero at 0.1%.
A senior BOJ official said fear among economists of not knowing the length and depth of the recession has been replaced by a 'sliver of hope,' thanks to improvements in export and production data. He added that the sustainability of the recovery remains 'a very big question.'
Many nations, including the U.S. and China, now face weaker consumer prices. But Japan, which was dogged by deflation from 1999 to 2005, faces a particular risk of persistent deflation as its aging and contracting population makes consumer demand in the nation inherently weak, with or without a recession, economists say.
'Continued weakening in prices could bring about spiraling declines in corporate profits, employment, and workers' income,' said Satoru Ogasawara, a Credit Suisse economist in Tokyo. 'That would push down final demand further.'
In Japan, government data are just beginning to reflect price declines throughout the country. To woo thrifty consumers, companies are relying on lessons learned during the last round of deflation, and in recent months have cut prices on items such as bread, blue jeans and sofas.
Faced with chronic declines in sales, top supermarket chains have resorted to an all-out price war, which, according to analysts, is cutting further into their earnings. Retailer Seiyu Ltd. started a campaign to match competitors' prices if customers brought in ads showing lower prices, borrowing a strategy of its parent company, Wal-Mart Stores Inc.
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