By Leika Kihara
TOKYO (Reuters) -The Bank of Japan laid the groundwork this week for resuming interest rate hikes by spelling out explicitly for the first time the risks that persistent food price rises fan broad-based inflation.
While markets took a dovish reading of BOJ Governor Kazuo Ueda's commentary after Thursday's policy meeting, much of his guidance suggests the bank is inching back towards action after a period of waiting and watching, analysts say.
A shift in the board's inflation bias and
its less gloomy view on the impact of U.S. tariffs also underscore the BOJ's resolve to pull the trigger once it is convinced the damage from higher levies will be within its expectations.
Such hawkish signals in the BOJ's quarterly report, which represents the board's consensus view on the policy outlook, were qualified by Ueda's comments suggesting he was in no rush to raise interest rates.
Still, Ueda said Japan was making some progress towards durably hitting the BOJ's 2% inflation target and stressed that its policy rate - at 0.5% - remains very low.
"It's not as if we will wait until underlying inflation is firmly at 2%. Our decision is dependent on how likely underlying inflation will reach that level," Ueda told a news conference on Thursday when asked about the next rate-hike timing.
All in all, the signals show the BOJ is preparing for another rate hike, while leaving all options open on the exact timing, analysts say.
"The outlook report clearly shows the BOJ is starting to lay the groundwork for a rate hike," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities.
"The BOJ seems confident about prospects for durably hitting its inflation target," she said. "It may not be in a rush, but signaling that every policy meeting from now will be live."
The BOJ holds its next policy meeting in September and another in October, when the board conducts a quarterly review of growth and price forecasts. It holds its final meeting for this year in December.
A Reuters poll last month showed a majority of economists expect another rate hike by year-end. Swap rates indicate a 54% chance the BOJ will raise rates to 0.75% in October and a 71% chance in December.
SECOND-ROUND EFFECTS
When the BOJ compiled its previous outlook report on May 1, Ueda signalled a pause in its rate-hike cycle as President Donald Trump's April announcement of sweeping "reciprocal" tariffs jolted markets and stoked fears of global recession.
Thursday's report showed signs the BOJ has ended that pause, as markets restored some calm and Japan's trade agreement with the U.S. in July reduced some uncertainty.
For one, the BOJ removed the word "extremely" in describing uncertainty over U.S. trade policy. While Ueda stressed the need to await more data on the impact from U.S. tariffs, he said the risk of the economy "falling off the cliff" has diminished.
The board also revised up its inflation forecast and said risks to the price outlook were balanced - a more neutral stance from that of May 1 describing risks as skewed to the downside.
Furthermore, the BOJ report for the first time included a detailed assessment of how rising food costs - once seen as transitory - may lead to broad-based price rises.
"It is possible that price rises will persist for longer than expected" as companies are passing on not just raw material but labour and distribution costs, the report said.
A steady rise in the price of items like food, which consumers buy frequently, may induce "second-round effects" on underlying inflation, the BOJ said in the strongest warning to date on mounting price pressure.
To be sure, food prices are among several factors the BOJ looks at in judging whether underlying inflation - or price rises driven by domestic demand - will durably hit its 2% target and justify raising rates.
Other measures show underlying inflation remains short of 2%, Ueda said, brushing aside the view the BOJ may be behind the curve in addressing the risk of too-high inflation.
But he said the BOJ must keep an eye out on how food prices and headline consumer inflation, which has remained above its target for well over three years, could affect inflation expectations.
In exiting a decade-long stimulus last year and raising rates to 0.5% in January, the BOJ pointed to growing signs companies were shedding their long-held aversion to price hikes.
Such change in corporate behaviour may be accelerating.
A total of 1,010 food and beverage items saw prices rise in August with more than 3,000 items likely to see higher prices in October, think tank Teikoku Databank said on Thursday.
"Food inflation will undoubtedly persist, which is probably why the BOJ highlighted the risk so clearly in the report," said veteran BOJ watcher Mari Iwashita.
"Once there's more clarity that wage hikes will continue, the BOJ might go ahead and raise rates."
(Reporting by Leika Kihara; Editing by Sam Holmes)
