Japanese policymakers are struggling over how to put a cap on the yen, which hit a 15-year high against the dollar this week and threatens to derail an export-led recovery.
Financial markets now expect the firmer yen will delay Japan's exit from deflation and nudge the Bank of Japan into easing monetary policy further, spurring a recent bull flattening of Japan's bond yield curve.
Given the yen's gains, exports will slump temporarily and slow Japan's economic recovery. Japan will thus remain in deflation for another two to three years, said Takeshi Minami, chief economist at Norinchukin Research Institute.
The BOJ may expand its fund-supply tool next month, but the effect on short-term interest rates will be limited. It needs to take bolder steps to beat deflation and the strong yen, such as increasing outright government bond purchases, although that's unlikely to happen soon.
Fears of deflation are no longer just limited to Japan.
The G3 nations could all see their yield curves flatten further if expectations for additional central bank easing heighten amid signs that their economies are losing momentum, analysts say.
Japan's core consumer price index (CPI), which includes oil products but excludes fresh food prices, fell 1.1 percent in July from a year earlier, data from the internal affairs ministry showed on Friday, matching the median market forecast. It was slightly bigger than a 1.0 percent drop in June.
The government, for its part, will outline measures on Friday to support the economy and grapple with the strong yen, Economics Minister Satoshi Arai told a news conference.
Kyodo news agency separately quoted Trade Minister Masayuki Naoshima as saying Prime Minister Naoto Kan would hold a news conference on Friday on steps to cope with the currency's rise.
But the government's chief cabinet spokesman said it was uncertain whether Kan would hold a news conference or simply speak to reporters on the sidelines of a visit to several small factories in Tokyo to hear their views on how the strong yen was affecting their businesses.
The yen eased slightly against the dollar to 84.75 yen after the report that Kan was to speak, but it is still up some 10 percent so far this year.
TROUBLE FOR CENTRAL BANK
The core-core inflation index, which excludes food and energy prices and is similar to the core index used in the United States, fell 1.5 percent in July from a year earlier.
Falls in the core CPI have been slowing since last summer as the economy's recovery from its worst post-war recession has helped to narrow the output gap.
But analysts say deflation may not ease much in the coming months as export growth slows before strength in corporate activity spreads to broader sectors of the economy.
That spells trouble for the BOJ, which has justified holding off on aggressive measures to beat deflation with its forecast that consumer prices will turn positive in the fiscal year ending in March 2012.
The BOJ is considering easing policy further at its next rate review on September 6-7, or even before that, but is seen opting for a minor tweak of its funding framework instead of bolder steps like increasing its government bond purchases.
Markets are already pricing in the chance of a BOJ easing. With short-term rates already very low, investors are pushing down the longer end of the curve, although the yield curve steepened on Friday as banks sold superlong bonds to take profits.
The BOJ is hesitant to return to full-blown quantitative easing since the policy, which involves flooding markets with extra cash under a liquidity target, had little effect in beating deflation when it was in place until March 2006.
The government is mapping out a series of steps to stimulate the economy, such as delaying the end of subsidies on purchases of energy-efficient electronics.
But any positive effect on the economy will be limited as spending under the stimulus plan will be small and any measures taken by the BOJ will be minor and cosmetic, analysts say.
(Writing by Leika Kihara; Editing by Edmund Klamann & Kim Coghill)