The Bank of Japan is expected to keep interest rates on hold at 0.5 percent this week as a slowing economy and gloom over corporate activity remain key concerns, with inflation still among the lowest in major economies.
Despite market expectations that the BOJ will follow the example of other big central banks and hike rates this year, it sees little need to shift to a tightening bias for now with Japan's economy hardly overheating and inflation not spreading much beyond food and energy prices.
"The BOJ's main worry is economic weakness, although it doesn't want to emphasise downside risks too much for fear of fanning inflation expectations," said Izuru Kato, chief economist at Totan Research. "It's hard for the bank to move either way, which means it will likely stick to a neutral policy stance for some time."
Faced with the prospect of weakening growth as soaring raw materials costs bite, the BOJ dropped a two-year bias towards raising rates in April to take a neutral stance on policy.
That is in contrast with the US Federal Reserve and the European Central Bank, which have both warned about inflation and signalled they were opting for rate hikes. Recent hawkish remarks by Fed and ECB officials heightened expectations that the BOJ will follow in their footsteps and hike rates later this year.
Swap contracts on the overnight call rate on Tuesday afternoon showed investors see a roughly 80 percent chance of a hike to 0.75 percent by the year-end, nearly double a roughly 45 percent probability seen in early trade.
While the BOJ sees rising public awareness of inflation as a risk, a rate hike would become an option only if inflation expectations begin to feed on themselves and prices of a wide range of goods shoot up on strong demand, BOJ sources said.
BOJ board members would also need to be convinced that economic uncertainties, such as slowing overseas growth, have cleared enough for Japan to achieve solid growth, they said. The BOJ's policy board is expected to announce its rate decision some time between noon and 2 pm (0300-0500 GMT) on Friday at the end of a two-day meeting. With no policy change expected, markets are focusing on what BOJ Governor Masaaki Shirakawa says about global inflation at a news conference due to start at 3:30 pm on Friday.
The BOJ had been working towards "normalising" rates in Japan, its parlance for raising the country's very low rates to more normal levels after nearly a decade of deflation. But the US subprime housing loan crisis has forced the central bank to take a more neutral stance lately. Economists expect rising energy and food prices to push up Japan's annual inflation, which stood at 0.9 percent in April, to near 1.5 percent or even 2 percent later this year.
Some within the BOJ believe there is a now bigger chance for the rise in core consumer prices to overshoot the bank's forecast of 1.1 percent in the fiscal year ending next March 31.
Even so, inflation is less a problem in Japan than in other parts of the world such as the euro zone, where it hit a record 3.6 percent in May. Japanese companies are only slowly passing on rising raw material costs in the prices of their goods as tame wage growth keep consumers' purse strings tight.
Weakness in the economy remains the BOJ's immediate concern, particularly with higher raw material costs hurting corporate activity, the key driver of Japan's economy. A government survey showed last week that corporate sales in the first quarter fell 1.5 percent to mark the first annual decline in five years, while recurring profits dropped 17.5 percent as raw material costs ate into profits.
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