BOJ FOCUS-Japan policy may be hostage to deflation for years

Published: 26 Aug 2009 21:58:24 PST

* BOJ may change forecast end of deflation to 2012 from 2011

* Other projections point to 8 years of deflation

* Rates to stay on hold until prices turn positive

TOKYO, Aug 27 - While the Bank of Japan publicly dismisses the idea the economy is sliding into a deflationary spiral, the internal policy debate is turning to scenarios in which prices fall for much longer than previously anticipated.

A longer spell of deflation could prevent the BOJ from raising interest rates for years and warrant an expanded policy response to the slump triggered by the global financial crisis.

"If you want to pull the economy out of long-term downtrend, you need very dramatic action. The BOJ needs to be more aggressive," said Dariusz Kowalczyk, chief investment strategist at SJS Markets in Hong Kong.

Even the more optimistic scenarios will probably see the BOJ pushing its forecast for the end of deflation into early 2012 rather than 2011, BOJ officials told Reuters.

Another projection BOJ officials discussed with Reuters suggests it may take as long as eight years to revive inflation, potentially undermining inflation expectations and deepening deflation enough to require further monetary easing.

Japan experimented with quantitative easing -- a policy of flooding the banking system with cash to promote lending -- to end a previous bout of deflation that lasted nearly a decade.

Inflation expectations will probably determine the policy response because they hold the key to the BOJ's view of what constitutes a "deflationary spiral".

According to the BOJ, an economy falls into a deflationary spiral when expectations of price declines so undermine demand that companies cut prices below cost and cover losses by slashing jobs and wages, making consumers even less willing to spend.

The BOJ says it expects Japan to avoid such a spiral and so do many analysts, including Kowalczyk.

Even if inflation expectations shift, the BOJ is unlikely to revert to full-blown quantitative easing, which in Japan involves setting a specific target for flooding the banking system with cash, BOJ officials said on condition of anonymity.

The more likely option would be for it to increase its annual purchases of government bonds from the current 21.6 trillion yen ($230 billion), or to commit to keeping interest rates very low.

NO RATE RISE SOON

In any event, Japan's key interest rate, now 0.1 percent, is unlikely to rise any time soon, almost certainly not before 2012.

"It would be hard to raise rates when prices are still falling. That's for sure," one BOJ official told Reuters.

Two other officials expressed the same view. All have direct influence over monetary policy and declined to be named because of the sensitivity of the matter.

A Reuters poll shows analysts expect the BOJ to keep rates steady at 0.1 percent at least until March 2011, which is when the central bank forecasts deflation will end.

The BOJ may now consider changing that forecast to expect deflation to persist until March 2012 when it issues its twice-yearly report on the economy in October.

There were good reasons for thinking that this round of falling prices would be shallower and shorter than the last, which began with a 1990s property market crash in Japan.

This time deflation started with the global economic downturn triggered by the collapse of the U.S. housing market, which led to bank failures in Europe and the United States.

The nature of the crisis and the relative stability of the Japanese banking system are among the reasons BOJ officials, including Governor Masaaki Shirakawa, have largely shrugged off the threat of a deepening spiral of deflation.

Unlike in Japan's last spell of deflation, the global economy is also in recession and demand is unlikely to recover quickly in Japan's key export markets such as the United States and Europe.

Core CPI, which in Japan includes energy prices, is falling at a record pace and is expected to show a 2.2 percent tumble in July from a year earlier in data to be released on Friday. That is more than twice as fast as in 2002, the low point in Japan's last bout of deflation that lasted from 1998 to 2005.

While the numbers are distorted by the collapse of an oil price bubble last year, slumping demand is weighing on prices.

Core-core CPI, which omits energy prices, fell 0.7 percent in June from a year earlier, the fastest slide in over four years.

"This shows that the country's widening output gap is playing an increasing part in pushing down prices," said Masaaki Kanno, chief Japan economist at JPMorgan Securities.

8 YEARS TO BRIDGE GAP

Japan's output gap, or the difference between the economy's potential and actual growth rates, hit a record minus 8.5 percent in January-March. The BOJ assumes the potential growth rate -- the rate at which the economy can expand at full capacity -- to be around 1 percent.

A rough calculation used by some of the BOJ officials suggests it would take Japan eight years of 2 percent GDP growth to bridge the output gap, and for prices to turn positive.

It may not take that long as Japan's potential growth rate may have fallen during this recession, the worst on record.

Still, consumer inflation may undershoot the BOJ's definition of long-term price stability -- inflation of between zero and 2 percent -- for longer than the BOJ now expects.

"If so, it could affect medium- to long-term inflation expectations," JPMorgan's Kanno said.

The BOJ's quarterly survey in July showed a median forecast among households is for price growth to remain flat a year from now and rise 2 percent in five years.

If this and other surveys show a dramatic change in the public's price outlook, such as expectations of four to five years of deflation, the need for a policy response might increase, BOJ officials said. ($1=94.00 Yen)