The Bank of Japan said Monday that it expects the world's number two economy to break decisively out of deflation by next year as it upgraded its forecasts to show 1.8 percent growth in the year to March 2007.
In an upbeat twice-yearly economic outlook, the central bank said the chances of a change to its expansionary monetary policy were likely to increase from April.
But it said interest rates would remain "very low" for a period after the first change to its policy, under which it floods the financial system with cash to try to stem consumer price falls and stimulate growth.
Bank of Japan governor Toshihiko Fukui told reporters an economic recovery now underway here is expected to be "extremely slow but long-lasting."
The central bank also raised its forecasts for gross domestic product growth to 2.2 percent in fiscal 2005 (ending in March 2006) from 1.3 percent previously, and to 1.8 percent in fiscal 2006 from 1.6 percent.
The growth projections are based on the forecasts of the members of the nine-strong policy board.
"The report is quite bullish. It emphasises very few downside risks to the outlook," said Stefan Worrall, an economist at Credit Suisse First Boston.
"It seems that they're putting a positive bias on the outlook on the economy and prices deliberately to brace the market for a normalisation of monetary policy."
The world's number two economy has been caught in the grip of deflation for more than seven years but is now on the road to recovery after a decade-long slump triggered by the bursting of Japan's "bubble economy" in the early 1990s.
Deflation is considered damaging for an economy because it deters individuals from spending today rather than tomorrow and hits company profits.
The central bank now expects consumer price changes to reach zero or turn positive towards the end of 2005.
It sees an average annual rise in core consumer prices of 0.1 percent in fiscal 2005, compared with a decline of 0.1 percent previously forecast.
Inflation is now expected to pick up to an annual pace of 0.5 percent in the fiscal year 2006 compared with an April forecast of 0.3 percent.
"If their bullish forecasts for inflation are correct then it would suggest a non-zero interest rate by the end of next year," said Worrall.
The Bank of Japan has vowed to keep pumping cash into the economy until deflation gives way to mild inflation as part of its near-zero interest rate policy.
It earlier decided as expected to leave its stimulative monetary policy unchanged as mild deflation continues.
Based on its forecasts, the central bank said the possibility of a change to the present monetary policy framework was "likely to increase over the course of fiscal 2006."
But the Bank of Japan said any rises in interest rates would be gradual. As a first step it is expected to end its current policy of making funds of 30-35 trillion yen (260-300 billion dollars) available to banks.
The report predicted "a period of very low short-term interest rates followed by a gradual adjustment to a level consistent with economic activity and price developments."
Overall economic activity had been more robust than predicted in April thanks to unexpectedly strong domestic private demand which more than offset lower-than-expected exports, it added.
"Japan's economy continues to recover, having emerged from the temporary pause that began in the second half of 2004," the report noted.
The adjustments in production and inventory in technology-related sectors, which caused the economy's soft patch last year, appear to have run their course, the central bank said.
"From the second half of fiscal 2005 through fiscal 2006, Japan's economy is likely to experience a sustained period of expansion at a pace slightly above its potential," the report predicted.
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