The Bank of Japan (BOJ) expects prices in Japan to continue falling until at least the end of 2011, it said in its half-yearly report Outlook for Economic Activity and Prices, which was released on Friday.
The news essentially means that the BOJ will keep interest rates at near zero until at least 2011. The bank said that despite the continuation of deflation, it expected deflation to slow down over the next two years.
"In an economy where prices continue to decline, whether the decline in prices will induce downward pressure on economic activity becomes a critical issue. Given that the pace of decline in prices is expected to slow down during the projection period, albeit modestly, and that the financial system and medium- to long-term inflation expectations are stable, it is unlikely that the decline in prices will induce downward pressure on economic activity," the BOJ said.
The report also said that Japan is heading for a recovery, after conditions deteriorated as shock waves from the credit crisis that originated in the United States spread across the globe. The bank noted, however, that while there have been some improvements in the manufacturing sector in recent months, domestic consumption remains weak.
"Private consumption remained generally weak amid the increasingly severe employment and income situation, although there were signs of a pick-up in durable goods consumption largely owing to the effects of various policy measures," the bank said.
The bank also noted that conditions within Japan are largely dependent on what happens to the global economy. It also noted that while household incomes remain weak and unemployment high, the economic situation will remain bad. Because of this, the bank said it does not expect a full recovery until next year.
"While Japan's economy is expected to remain on a recovery trend in fiscal 2010, the pace of improvement is likely to be moderate until around the middle of fiscal 2010," the bank said. "This is because the pace of recovery of the global economy is likely to remain moderate and also because, in Japan, pressures to adjust employment and wages are likely to remain, while effects of demand-boosting policy measures wane."
The report said that it did not expect to see domestic spending and household incomes improve until "the latter half of the projection period, which runs through to 2011".
The bank said that a number of risks remain that could undermine any economic recovery, including the consequences of recovery attempts in Europe and the United States. The bank noted that "in a number of cases including that of Japan, the scale and duration of the adjustment were greater than initially envisaged."