Japan to end some crisis steps despite deflation risk

Japan's central bank said Friday it would wind down some of its emergency stimulus measures, but warned Asia's biggest economy faced years of deflation as it claws back from its worst slump in decades.

Japan's economy showed fresh signs of a recovery with the jobless rate falling to a four-month low in September and household spending rising.

But the improvement was overshadowed by fears of another long bout of deflation as seen after Japan's economic bubble burst in the 1990s.

The Bank of Japan warned that consumer prices would fall for three straight years -- by 1.5 percent this year, 0.8 percent next year and 0.4 percent the following year.

Japan could even face a decade of deflation, said Glenn Maguire, chief Asia economist at Societe Generale in Hong Kong.

"In the absence of deep-seated structural reforms that lift potential growth," he said, "the crisis will prove to be the tipping point for the slow atrophy of the Japanese economy to begin."

Japan was stuck in a deflationary spiral for years after its asset price bubble burst in the early 1990s, hitting corporate earnings and prompting consumers to put off purchases in the hope of further price drops.

The BoJ's decision to end in December purchases of corporate debt that were part of a fight against the credit crunch sets the stage for possible tensions with the government.

Tokyo has urged the bank to be careful not to snuff out a nascent recovery by tightening policy too soon and Financial Services Minister Shizuka Kamei has even accused the BoJ of "talking in its sleep".

Governments and central banks around the world face the tricky task of deciding when to withdraw emergency measures aimed at shoring up their economies in the face of a brutal global slump.

Japan's central bank left its key interest rate unchanged at 0.1 percent at its meeting on Friday and pledged to continue a highly stimulative monetary policy to support the economy.

"It may take some time until the Japanese economy returns to a full-fledged growth track," BoJ governor Masaaki Shirakawa told reporters.

"The BoJ will keep providing support by keeping financial conditions extremely accommodative," he added.

Japan's economy is set to shrink 3.2 percent in the year to March 2010 before rebounding 1.2 percent next year and 2.1 percent the following year, the central bank said in a twice-year report.

A batch of reports released Friday reinforced the picture of an economy that is slowly getting back on its feet.

The unemployment rate fell to 5.3 percent in September, beating market expectations for an increase to 5.6 percent. Household spending gained 1.0 percent in September from a year earlier, up for a second straight month.

Core consumer prices dropped 2.3 percent in September from a year earlier, after an unprecedented 2.4 percent slump in August.

But analysts said the recovery shoots were largely due to a temporary boost from the government's economic stimulus measures.

"As the stimulus effect fades, and income declines widen again with winter bonus cuts, we expect renewed weakness for personal consumption ahead," warned Morgan Stanley economist Takehiro Sato.

-- Dow Jones Newswires contributed to this story --