AFTER eight years of falling consumer prices, 2006 looks set to be the year that Japan says 'sayonara' to deflation as the world's number two economy awakes from a decade-long slumber.
Japan passed some key milestones in 2005 as Prime Minister Junichiro Koizumi gambled his leadership and won a mandate to press ahead with economic reform, including the privatisation of the postal system and its massive savings bank.
The Tokyo stock market jumped about 39 per cent to levels not seen for over five years as investors bet that following a series of false dawns, this time the economic recovery in Japan is for real.
"Japan is emerging into a reliable Pacific powerhouse," Merrill Lynch economist Jesper Koll wrote in a research note, forecasting economic growth here of 3.0 per cent in 2006, up from 2.5 per cent in 2005.
"After years of stagnation marked by relatively short-lived growth spurts, we think Japan's macro- and micro-economy is finally ready to fulfill its longer-term high growth potential," he added.
However, the government and the Bank of Japan are both taking a somewhat cautious view of prospects for growth.
The Bank of Japan forecast gross domestic product growth will slow to 1.8 per cent in the fiscal year to March 2007 from 2.2 per cent the previous term.
The government for its part expects the economy to grow only 1.9 per cent in fiscal 2006, below the 2.7 per cent expected in the current year.
At the same time, deflation finally appears to be ending with core consumer prices holding steady in October year-on-year, ending a four- month streak of minor declines.
The Bank of Japan and the government expect consumer prices will rise 0.5 per cent in the year to March 2007, marking the first increase in eight years.
Analysts believe that economy will return to modest inflation by early 2006, setting the scene for the Bank of Japan to end its super- expansionary policy.
"Japan will say sayonara to deflation in 2006 but the goodbye will be prolonged," predicted Robert Feldman, chief economist for Japan at Morgan Stanley.
"Fortunately, the delays in saying goodbye to deflation will only give the economy more ability to solidify structural gains. With strong productivity growth continuing, both profits and wages can rise, while prices stay subdued and real growth becomes more self-sustaining," he wrote in a note to clients.
The Bank of Japan has been flooding the banking system with cash since March 2001 in an effort to stem falls in consumer prices and stimulate growth in addition to keeping interest rates effectively at zero percent.
The central bank has signalled that an end to this "quantitative easing" policy is likely sometime after the end of the current fiscal year in March.
"The chances are growing that the framework of our exceptional management policies against the deflationary spiral will change during the next fiscal year," Bank of Japan Governor Toshihiko Fukui said in a recent speech.
However, the central bank is expected to maintain interest rates effectively at zero into 2007 and is also under pressure by Koizumi's government not to rush to end its quantitative easing policy for fear of a return to deflation.
"In our view, Japan's policymakers are in no rush to tighten," said Koll at Merrill Lynch.
"We expect the Bank of Japan to start adjusting down quantitative easing from April-June 2006 but rates are set to stay anchored at zero for another year," he predicted.
One cloud lurking on the horizon is the possibility of a rise in the consumption tax as part of plans to strengthen government finances but Koizumi has ruled out a hike anytime soon.
With Koizumi planning an exit the scene in 2006, the outlook for further structural reform is also murky.