The Japanese economy remains in a serious deflationary situation even while experiencing a cyclical recovery phase in mid 2002 underpinned by inventory correction and a sharp pick-up in exports. But the recovery is too narrowly based to represent a break with the pattern of generally low growth experienced through the 1990s. The still high capital/ output ratio is likely to limit any pick-up in investment to a short term adjustment, while continuing weakness in the labour market is expected to restrain consumption growth to around one per cent per annum. More recently, a combination of factors – particularly low share prices in Japan and elsewhere, a marked appreciation of the yen and a moderating export expansion – has dampened growth prospects going into 2003. All in all, the economy may grow by only around ½ to 1 per cent per annum to the end of 2004 with deflation continuing. But the balance of risks is now on the downside given signs of slower growth in the world economy and the possibility of a further deterioration in financial conditions, which might lead to a worsening of deflation. Thus Japan continues to be faced with the daunting challenge of radically and quickly improving the functioning of its economic system and halting deflation...