TOKYO, July 22, 2009 (AFP) –
Deflation is set to deepen in Japan but the world's number two economy should avoid a "vicious circle" of falling consumer prices leading to a weaker economy, a top central banker said Wednesday.

Year-on-year falls in consumer prices "will likely accelerate for the time being" but moderate from the second half of this financial year to March 2010 as the economy recovers, Bank of Japan deputy governor Hirohide Yamaguchi said.

"The Bank therefore thinks it unlikely at present that prices will continue to decline and thereby lead Japan's economy into a deflationary spiral," he said in a speech to business leaders in the northern city of Hakodate.

Japan was stuck in a deflationary spiral for years after its asset price bubble burst in the early 1990s, prompting consumers to put off purchases in the hope of further price drops and reducing corporate earnings.

Fears of another prolonged bout of deflation are growing. Core consumer prices fell a record 1.1 percent in May from a year earlier, while wholesale prices dropped by an unprecedented 6.6 percent in June year-on-year.

The Bank of Japan last week announced it would extend its emergency measures to tackle the worst recession in decades, but it also noted that economic conditions "have stopped worsening."

It has reduced its key interest rate to 0.1 percent since the economic crisis erupted and has been buying up corporate debt to keep credit flowing to cash-strapped firms.

Japan entered recession in the second quarter of 2008 as its heavy dependence on overseas demand to drive growth left it highly exposed to the global downturn.

The economy shrank at an annualised pace of 14.2 percent in the first quarter of 2009, the worst performance on record, but recent data have indicated that exports and industrial production have begun to rebound.