Japanese Bank Note
The word Yen is pictured on a Japanese bank note at Interbank Inc. money exchange in Tokyo. Reuters

Japan’s consumer prices declined in June indicating that the country’s economy continues to be affected by the soft global demand, the worsening crisis in the euro zone and the strengthening yen.

The data released Friday by Japan’s Statistics Bureau show that consumer prices declined to 0.2 percent in June from the earlier year. Policymakers agree that one of the government’s most important goals is to beat deflation.

A main reason for the existence of deflation in Japan is due to the shortage of demand relative to the supply capacity of the economy. The negative output gap is estimated to be 3.5 percent of the gross domestic product (GDP), meaning that the demand is around 17 trillion yen ($217 billion) less per year than the potential supply. How the government addresses this will, in effect, indicate whether it can achieve the target of 3 percent nominal GDP growth per annum through 2020, with inflation of 1 percent, meaning that the economy should achieve a 2 percent annual real growth.

Policymakers feel that deregulation can help along with the Bank of Japan (BoJ) continuing with its monetary easing measures. Increasing the labor market participation would also be a step in the right direction as more people working would translate into higher national earnings and higher spending.

Another major worrying factor is the strengthening of the yen, especially due to global factors. The revival of the euro zone crisis has prompted a renewed flight to safe investment opportunities. The yen has appreciated sharply against the euro to its highest level since 2000, and strengthened against the dollar back into the 78-79 range. Earlier this month, the Japanese Finance Minister Jun Azumi warned markets that he was ready to intervene as it was necessary to prevent the yen from appreciating further, since it did not reflect the real state of Japan’s economy.

A weaker yen would help the Japanese exporters, but the Ministry of Finance is unlikely to succeed in delivering it while investors seek to escape the euro zone crisis. With the expectation that the euro zone crisis could escalate further, this is likely to push the yen up sharply and unilateral intervention is unlikely to be that much of an offset on its own.

Meanwhile, the BoJ could ease monetary policy further and, indeed from its statements this month, it would do so if the strong yen threatens the economy, possibly a coded warning of further asset purchases.