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A return to deflation is a nightmare scenario for Japanese policymakers after years of arduous efforts to prevent prices from falling, but the coronavirus pandemic is raising fears that it may become a reality.

The economy is increasingly facing downside risks following a second state of emergency declared over the novel coronavirus, which is in place until Feb. 7 in Tokyo, Osaka and some other prefectures, hitting demand especially in the services sector.

With annual wage negotiations between management and labor unions getting into full swing in February and March, companies appear reluctant to raise pay after a difficult 2020 and ahead of an uncertain 2021.

Tepid wage growth bodes ill for consumption, a key component of the economy, as households would become even more cautious about spending.

Economists say there is also a question mark over how fast and by how much demand will recover once the current resurgence of the coronavirus is brought under control.

“The battle to prevent deflation is only beginning,” said Shunsuke Kobayashi, chief economist at Mizuho Securities Co. “We have not stepped into the (deflation) zone. But inflation expectations have been weakening and it’s hard to predict prices will follow an upward trend now.”

In December, core consumer prices plunged 1.0% from a year before, marking the steepest fall in over a decade and the fifth straight month of decline.

Prime Minister Yoshihide Suga’s drive to spur domestic tourism, an industry reeling from the pandemic, through a subsidy program and achieve substantial cuts in mobile phone fees by major carriers are seen as negative for the consumer price index (CPI), a gauge of inflation.

At the same time, Suga has stressed the importance of pay hikes this year to prevent Japan “at any cost” from reverting to deflation.

After a 0.5% fall in the current fiscal year through March, the core consumer price index, excluding volatile fresh food, is predicted by the Bank of Japan to rise 0.5% in the upcoming year.

The projection is viewed as rather upbeat, as planned fee cuts by major mobile carriers have not been factored in. Taking heed of government pressure, NTT Docomo Inc., KDDI Corp. and SoftBank Corp. have announced cheaper options for data usage, starting in March or April.

Downward pressure on prices is building, as the BOJ is reviewing its policy tools now that the spread of the coronavirus has pushed its 2% inflation target further away.

BOJ Gov. Haruhiko Kuroda views low crude oil prices and the Go To Travel campaign as “temporary” factors weighing on the CPI and has not sounded the alarm.

“Consumers are intentionally reducing (the use of) face-to-face services to prevent infection now, which is different from falling demand under normal times,” Kuroda said after a two-day policy meeting in January. “We have to bear in mind that under such circumstances, companies would have little incentive to draw demand with price cuts.”

“At present, we don’t think the risk of deflation is extremely high,” the governor said. In deflation, prices continue to fall.

Economic activity has yet to return to normal, as people are urged to stay at home and restaurants requested to close at 8 p.m. in the 11 prefectures under the state of emergency.

The current state of emergency is limited compared with the nationwide one in the spring of 2020. Japan’s output gap, a gauge of supply and demand, was negative for the second straight quarter in July to September, according to BOJ data.

In the aftermath of the collapse of U.S. investment bank Lehman Brothers, the government started to use the term “deflation” in its monthly economic report in November 2009 and continued to use it until December 2013.

Some retailers have already offered cheaper products to help households, including supermarket operator Seiyu G.K., which last year cut prices on over 700 daily necessities by some 5% on average.

The focus is now on how companies will tackle this year’s shuntō wage talks, because the outcome will affect people’s mindsets and the prospects of Japan reverting to deflation.

Suga’s predecessor, Shinzo Abe, repeatedly asked companies to raise wages during his time in office that ended last year. This year, many companies have seen their earnings severely hurt by the global health crisis and base pay hikes will be difficult, according to economists.

Keidanren, the country’s most powerful business lobby, has said it is “unrealistic” to expect pay increases across the board.

For the current fiscal year through March, big companies in both the manufacturing and nonmanufacturing sectors expect pretax profits to plunge 34.6% from a year ago, according to a BOJ survey.

“The extent of damage (to earnings) from the pandemic is different among companies, but the overall push on the part of labor unions calling for base pay hikes will be rather weak,” said Yoshiki Shinke, chief economist at the Dai-ichi Life Research Institute.

Management and labor unions will pay more attention to maintaining employment and avoiding pay cuts this year, with work-style reforms another key agenda item.

Annual wage negotiations will result in a 1.86% pay increase among major companies covered in a government survey, falling below 2% for the first time since 2013, according to Shinke. The figure for 2020 was a rise of 2.00%.

Economists say changes to basic pay and consumption are strongly correlated. “It’s the basic salaries that will determine the path forward (for households),” Mizuho Securities’ Kobayashi said.

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