The D Word Is Back

They call it the "D Word." For more than a decade--ever since the bubble burst in the early 1990s, sending prices for basic goods and services plummeting--Japanese prime ministers have been dreaming of a day when they could announce the end of deflation, a rare and crippling syndrome in which falling prices sap a nation's buying energy and investing confidence. Yet they also feared it. And so came the odd day in January when Japan's central bank retreated from declaring victory and decided not to raise interest rates, after members of Prime Minister Shinzo Abe's cabinet warned that it was too soon. Deflation still looms.

New data suggest that the politicians were right to worry. At the heart of the bad news is the cost of consumer goods. For most of 2006, Japan's consumer price index (CPI) had hovered just above zero. But the figure for December, released just days after the central bank's decision, showed a slight dip. The immediate reason: a drop in oil prices, which now seem likely to stay relatively low for the near future. But oil was not the only culprit. Unlike the CPIs of some other countries (including the United States), Japan's includes prices for both fresh food and energy. Strip out both those elements and Japan has actually been in deflation all along, with prices falling 0.3 percent in 2006 (some experts say the decline was even worse). Observers now argue that even the more generous "headline CPI"--that is, the index that includes energy and food prices--may not break zero in the next year.

Economists are divided over why exactly prices in Japan have remained so low. Some argue that Japanese companies are to blame for not passing along their swelling profits to their employees in the form of wage increases, which has dampened consumption. Others point to sluggish bank lending; Japanese companies, which these days are flush with cash, haven't had to go to the banks as often for loans. Still other experts blame low-cost imports from China and elsewhere for driving down the cost of everything from flat-screen TVs to mobile-phone chargers--but that fails to account for why deflation isn't more of a problem in Europe or the United States. A more likely explanation for Japan's woes is the enduring caution of its economic decision makers, who vividly recall the trauma of the country's postbubble economic malaise and so are reluctant to invest in real estate or boost workers' earnings. Even Japan's labor unions seem to share this conservatism and have been conspicuously silent on the matter of their members' stagnant wages.

But is the absence of inflation really cause for alarm, as Abe's government has suggested? Optimists point out that even with a low CPI, Japan's economy has been enjoying its longest expansion since the second world war--the recovery has been underway for well over five years now. While that's true, however, a mere whiff that deflation is back can be psychologically jarring, notes Richard Jerram, chief economist at Macquarie Securities in Tokyo. He points out that, given present conditions--a very weak yen, the relatively low price of oil and Japan's recent 2 to 3 percent growth rate--one might have reasonably expected an inflation rate of, at the very least, half a percent this year. The fact that Japan failed to reach that level is a sign that consumers and investors are still reluctant to put their faith in the country's recovery.

Indeed, the specter of deflation is having immediate and worrisome effects. The Bank of Japan is now extremely unlikely to increase rates until prices start rising again, because it's afraid of further depressing consumption. That means the yen will probably stay weak, which could have dangerous consequences. After all, the low value of the yen (along with low interest rates) has fueled the so-called carry trade, in which investors take advantage of rock-bottom rates to borrow yen in Japan that they then put into higher-yielding investments elsewhere. No one knows just how much money is involved in this process, but if the yen were to rise precipitously (due to a sudden panic among individual investors, for example), participants in the process might be caught short, which could end up destabilizing the global financial system.

Some economists say such fears are overblown. And many argue that Japan's economy will continue to grow even in the absence of clear-cut inflation. Still, the bad news about prices and the central bank's decision to avoid a rate hike have served at least one possibly beneficial purpose: to remind investors and businesspeople just how far from economic "normality" Japan remains.