Japanese consumer prices fell at the fastest pace on record last month, data showed yesterday, stoking fears that the world's second largest economy is set for another long bout of deflation.
The steep decline in prices came despite growing hopes that the Japanese economy has come through the worst of its deepest recession on record.
Core consumer prices fell 1.1 per cent in May from a year earlier, the sharpest decline since comparable records began in 1970, the government said.
"We must carefully manage the economy so that it does not collapse further and enter into a deflationary spiral," Finance Minister Kaoru Yosano said.
Core prices, which exclude those of volatile fresh food, fell for the third straight month.
The decline reflected weak domestic demand and the impact of lower oil costs, said Hiroshi Watanabe, an economist at the Daiwa Institute of Research.
"Deflation is taking hold," he said, suggesting the Japanese economy would likely remain frail for the foreseeable future.
While lower energy costs are good news for many consumers and companies, analysts said it was worrying that deflation appears to be taking root across the broader economy, in part because of sluggish wages.
Japan was stuck in a deflationary spiral for years after its asset price bubble burst in the early 1990s, leaving the country mired in a long recession and prompting the central bank to slash interest rates to almost zero.
Deflation eroded corporate earnings and encouraged consumers to delay their spending in the hope that prices would fall further.
Consumer prices are likely to show bigger year-on-year declines in the coming months due to weak domestic demand, analysts said.
"It looks like Japan is heading for another lengthy period of deflation," warned Macquarie Securities economist Richard Jerram.
Against this backdrop, the Bank of Japan looks set to hold its key interest rate at the current low level of 0.1 per cent for "a lengthy period", he added.
Japan's economy suffered its worst contraction on record in the first quarter of 2009, shrinking at an annualised pace of 14.2 per cent as exports collapsed during the global economic downturn.
Recent data have sparked hopes that the worst of the slump in exports and industrial production is now over.
The Bank of Japan's closely watched Tankan survey of business confidence, due to be released next Wednesday, is expected to show a sharp improvement in sentiment from a record low the previous quarter, according to forecasters.
The survey "should bring hard evidence that the worst is over," predicted Morgan Stanley economist Takehiro Sato.
But at the same time, analysts warned that Japanese consumers and companies are likely to remain cautious about spending, leaving the economy highly dependent on foreign markets to drive any recovery.
"We expect domestic demand to be hobbled by fixed-cost cutting and industry realignment by companies striving to survive," Mr Sato wrote in a note.