June 26 (Bloomberg) -- Japan may be sinking into deflation that will undermine the nation’s rebound from its worst postwar recession, the Cabinet Office’s chief economist said.

Deflation “will exert a significant amount of downward pressure on the recovery,” Jun Saito, an adviser to Economic and Fiscal Policy Minister Kaoru Yosano, said in an interview yesterday in Tokyo. “An increase in deflationary expectations will raise real interest rates and that will restrain business investment.”

Consumer prices excluding fresh food dropped a record 1.1 percent in May from a year earlier, the statistics bureau said today, spurring concern that the economy is slipping back into the deflation that plagued the nation for a decade until 2005.

“Declining prices will mean lower profits, less investment and wage cuts that will weaken consumer spending further,” said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co.

According to Saito, who quantifies the risk of deflation by using government data and figures from the International Monetary Fund, the risk of persistent price declines climbed to the highest level since 2003 and almost doubled since last year.

“I think there’s a risk we may slip back into deflation,” Saito said, adding that he defines it as a sustained decline in prices.

Yosano said today that an “extreme” slump in demand and declines in production are causing prices to drop. “We continue to monitor developments in prices and need to carefully manage the economy to avoid a deflationary spiral,” he said.

Delayed Purchases

During Japan’s last tussle with deflation, consumers delayed purchases, eroding profits and forcing firms to cut wages. Bank of Japan Governor Masaaki Shirakawa said last week that he is “cautious” about the strength of rebound in demand overseas and home.

Japanese companies cut spending at the fastest pace in 54 years in the three months ended March 31. Wages have dropped for 11 months and households reduced spending for a record 14th month in April.

Falling prices are a blow to households who borrow money because it makes it harder to repay debt, Saito said. Consumers will cut back spending if entrenched price declines push up their borrowing costs, he added.

The output gap, a measure of the balance between demand and supply in the economy and regarded as a key gauge to price trends, fell a record 8.2 percent in the three months ended March 31, government data show.

The Organization for Economic Cooperation and Development also voiced concern about prices this week, urging Japan’s central bank to keep adding extra funds to the banking system.

“The Bank of Japan should fight deflation through a strong commitment to implement effective quantitative measures until underlying inflation is firmly positive,” the Paris- based OECD said in its semiannual outlook report.

To contact the reporters on this story: Toru Fujioka in Tokyo at tfujioka1@bloomberg.net; Tatsuo Ito in Tokyo at Tito2@bloomberg.net

Last Updated: June 25, 2009 22:00 EDT