After several months of rising consumer prices, Japan's core consumer price index fell by 0.1% in October, a sign that the country might continue to suffer through deflation.

Although the Japanese government blamed the fall in prices on a cigarette tax and insurance premiums that were introduced during October a year earlier, the news could lead to a loss of investor confidence in Japan's ability to get its economy back on track. However, the fact that investors have more faith in Japan's government than the governments of countries like Greece, Italy and Spain is partially to blame for Japan's deflation problem.

The European sovereign debt crisis has caused investors to look for safe haven currencies as many are questioning whether or not the euro currency is doomed. This has caused currencies like the Japanese yen and the Swiss franc to climb higher compared to the euro. With the Japanese yen at near record highs, consumers have seen the cost of many imports fall.

Fear that the troubled eurozone economies could drag the rest of the world into recession has also hurt commodity prices, which in turn has contributed to falling consumer prices in Japan. Energy prices are one of the few segments to see cost increases and have climbed higher in Japan since the devastating earthquake and tsunami forced the government to shut down many nuclear reactors. Excluding the rising cost of energy, the October price drop would have been much greater.

The combination of a rising yen and lingering deflation could weigh on the Japanese economy for years to come. The rising yen makes Japanese exports more expensive during a time when consumers in the United States and Europe are looking for ways to save money.

The International Monetary Fund warned earlier this week that Japan needs to find a way to get its economy growing again. Otherwise, Japan might find itself in a similar position as eurozone countries like Spain and Italy that have seen their borrowing costs surge higher as investors lose confidence in them.

ACTION ITEMS:



Bullish:

Traders who believe that Japan's October price drop is not a sign of things to come might want to consider the following trades:



If Japan's economy improves and the country experiences healthy levels of inflation, the iShares MSCI Japan Index Fund (NYSE: EWJ) should climb higher. The October price rise followed months of increasing prices, so Japan isn't necessarily back to its inflationary ways.

Bearish:

Traders who believe that the latest drop in Japanese consumer prices is a precursor to years of deflation may consider an alternate positions:



The ProShares UltraShort MSCI Japan (NYSE: EWV) will see its share price rise if Japan isn't able to get its economy growing again and prices continue to fall.

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