Japan’s economy — the second-largest in the world and a barometer of global consumer demand — was described yesterday as being “on a knife-edge” amid fears that it might plum- met into deflation within months.

The warnings, which come from senior private sector economists and from the Japanese Government, follow a Boxing Day release of dismal industrial, consumer and employment data.

Within hours of passing a record 88 trillion yen (£660 billion) budget, senior government sources told The Times that Japan would “inevitably” be forced to adopt new measures to halt the meltdown. The country’s spiraling economic crisis arises primarily from the sudden halt in American consumption and the acute slowdown in the flow of components and goods throughout Asia. The strong yen has savaged the competitiveness of Japanese goods such as cars and electronics at a critical moment.

A record-breaking fall in industrial output figures for November showed that the country’s huge manufacturing economy is collapsing far more rapidly and painfully than even the bleakest market forecasts believed possible. The 8.1 per cent month-on-month slide — a dramatic collapse from the 3.1 per cent decline logged in October, stunned many economists. Richard Jerram, of Macquarie Securities, said that the pace of collapse had almost gone beyond the point of sensible analysis.

Employment is on track to fall rapidly as companies retrench at a pace not seen even during the worst days of Japan’s “lost decade”. Economists at Nomura said that even though the employment figures suggested a measure of stability, deterioration is “unavoidable” as companies retract job offers and lay off temporary workers.

The rate of consumer price growth dropped at its fastest pace since 1981: as commodity and energy prices nosedive on global markets, food is now the only component of the Japanese consumer price index that is still in positive territory.

Kyohei Morita, senior economist at Barclays Capital in Tokyo, yesterday brought forward to May his forecast of when Japan will once again confront deflation — a rare economic malaise that crippled the nation during the late 1990s.

He pointed to the growing number of retailers — from luxury goods boutiques to family restaurants — which are passing the benefits of the strengthening yen on to customers in “strong yen sales”. These have in turn pushed consumer prices lower more quickly than anyone predicted.

Reflecting growing panic within the Japanese Government, and the darkening prospects for immediate recovery, Kaoru Yosano, the Economy and Fiscal Policy Minister, said that “both Japan and the world will be on knife’s edge for some time.”

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