Nov. 21 (Bloomberg) -- Japan’s government and central bank clashed over the threat of deflation, indicating Prime Minister Yukio Hatoyama may want stronger monetary stimulus to buttress the economy’s recovery.

The Bank of Japan yesterday said growth is “picking up,” and Governor Masaaki Shirakawa said public expectations for consumer prices remain stable. By contrast, Finance Minister Hirohisa Fujii said there’s a “sense of crisis” over deflation and Deputy Prime Minister Naoto Kan urged the central bank to take action to overcome the price slump.

Hatoyama’s administration, which took office in September, is signaling it wants the central bank to step up its purchases of government bonds from the current 1.8 trillion yen ($20 billion) a month to inject more cash into the banking system, analysts said. Shirakawa said yesterday that liquidity alone won’t raise prices.

“Given the bank’s independence, the government can’t ask the BOJ directly to cut rates or buy more bonds,” said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co. in Tokyo. “That’s why it’s using this term ‘deflation’ to force the BOJ to step up its accommodative measures.”

The policy board kept the overnight lending rate at 0.1 percent at yesterday’s meeting in a unanimous decision, and Shirakawa pledged to maintain low borrowing costs. The BOJ will keep the benchmark rate on hold through 2010, according to 15 of 17 economists surveyed by Bloomberg News this month.

Shares Slump

Sustained price declines threaten to curtail a corporate profit rebound that’s already been insufficient to spur a rally in Japan’s shares this quarter. The Nikkei 225 Stock Average sank 2.8 percent this week, its sharpest slump in seven weeks.

While gross domestic product grew an annualized 4.8 percent last quarter, the fastest pace in more than two years, a gauge of prices excluding imports tumbled the most in 51 years, a Cabinet Office report showed this week.

Discounts by retailers from Aeon Co. to Fast Retailing Co. are helping push down consumer prices, which slid 2.3 percent in September, a seventh drop. The central bank said last month it expects them to keep sliding through fiscal 2011.

“Given the tremendous decline in demand through the early part of this fiscal year, downward pressure on prices will probably linger for quite some time,” Shirakawa said, adding that the government shares the view. He said they are falling because of weak corporate and consumer demand and policy makers should work to boost growth expectations and spending.

Deflation Declaration

The Cabinet Office said yesterday that Japan “is in a mild deflationary phase,” referring to declining prices in its monthly economic evaluation for the first time since June 2006.

“I expect monetary support from the central bank in order to overcome these deflationary conditions,” Kan said.

Finance Minister Fujii called on the central bank to respond to the deflation threat, while acknowledging rates are already “very low,” limiting room for further monetary action.

“The government’s surprise declaration is less of a sudden change in its price outlook than a step toward loosening fiscal discipline,” said Junko Nishioka, chief economist at RBS Securities Japan Ltd. in Tokyo. She said the central bank would resist pressure to increase bond purchases and instead state a commitment to keep rates low for a specific period.

Deflation blighted Japan during its so-called lost decade of stagnation after an asset bubble burst in the early 1990s. The central bank responded by flooding the economy with cash in so-called quantitative easing from 2001 to 2006, a policy that Shirakawa has said had limited impact on economic growth.

OECD’s Suggestion

The Organization for Economic Cooperation and Development said this week that an increase in the Bank of Japan’s government bond purchases would combat deflation by adding liquidity to markets and pushing up price expectations.

Increasing the monthly debt buying may also help to contain long-term interest rates as the government struggles to restrict the budget amid a slump in tax revenue. Shirakawa has said the debt purchases aren’t aimed at funding fiscal spending or propping up bond markets.

Yields on 10-year government bonds climbed to a four-month high on Nov. 10 on concern that spending by the Hatoyama administration will increase a public debt burden that’s approaching twice the size of the economy. They have since retreated to 1.305 percent.

“Sure, more fiscal spending by the government combined with more bond buying by the central bank may make it easier for Japan to get rid of deflation,” said Masaaki Kanno, chief economist at JPMorgan Chase & Co. in Tokyo, who used to work at the central bank. “But it’s problematic if the central bank keeps raising bond purchases without limit.”

To contact the reporters on this story: Mayumi Otsuma in Tokyo motsuma@bloomberg.net; Toru Fujioka in Tokyo at tfujioka1@bloomberg.net

Last Updated: November 20, 2009 10:01 EST