By Leika Kihara
TOKYO (Reuters) -The Bank of Japan is preparing markets for a possible interest rate hike as soon as next month, sources say, reviving previous hawkish language as worries about sharp yen declines return and political pressure for the bank to keep rates low fades.
A change in BOJ messaging over the past week has shifted focus back to inflationary risks of a weak yen from earlier worries about the U.S. economy, comments aimed at reminding markets a December rate hike was still a prospect,
two people familiar with the bank's thinking told Reuters.
The pivot back to a hawkish footing also follows a key meeting between Prime Minister Sanae Takaichi and BOJ Governor Kazuo Ueda last week, that appeared to remove immediate political objections to rate hikes from the new administration.
To be sure, the decision to raise rates in December or hold until January remains a close call with the U.S. Federal Reserve's rate decision - which comes a week before the BOJ's - seen swaying yen moves, said one of the sources.
However, recent remarks from various officials including Ueda reflect a growing view within the bank a weak yen has become a trend and could drive up inflation more than in the past, both sources said.
"It's clear the BOJ is intentionally dropping signals now to ensure it won't surprise markets in case it decides to hike rates in December," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities.
A Reuters poll showed a slim majority of economists expect the BOJ to hike rates at its next meeting on December 18-19. All of them project a hike to 0.75% by March next year.
HAWKISH CHORUS GETS LOUDER
A growing number of board members see conditions ripe to hike. Junko Koeda said last week the BOJ must keep raising real interest rates as prices have been "relatively strong."
Kazuyuki Masu said the timing of a rate hike was "nearing" in an interview published on Saturday - remarks that pushed up the 5-year government bond yield to a 17-year high on Tuesday.
The comments open scope for Koeda and Masu to join two other hawks in the nine-member board who proposed, unsuccessfully, in September and October to raise rates to 0.75% from 0.5%.
Even Ueda, seen by markets as the most dovish on the board, told parliament on Friday the BOJ would discuss the "feasibility and timing" of a rate hike in upcoming meetings - a change in tone from previous remarks it had no preset timing to shift policy.
More importantly, a weak yen could affect underlying inflation - a key gauge the BOJ looks at in deciding how soon to raise rates, signalling it now sees currency moves having more lasting price impacts.
REAL DESIRE FOR NORMALISATION
Having raised rates to 0.5% in January, the BOJ has since kept borrowing costs steady on caution over the economic hit from U.S. tariffs.
The slow pace of BOJ rate hikes has been among drivers of a weak yen, which accelerates inflation by pushing up import costs.
And Ueda is losing reasons to hold steady.
The impact of U.S. tariffs has been limited so far. Early signs on next year's wage talks point to more solid pay hikes, clearing another reason for Ueda's caution.
While the inauguration of Takaichi, a fiscal and monetary dove, last month has complicated its decision, renewed yen falls have firmed the case for a near-term hike.
As the yen slumped to 10-month lows against the dollar, Finance Minister Satsuki Katayama said last week she had "no particular objection" to the BOJ's rate-hike path, and that the government and central bank will stay vigilant to market moves.
After his meeting with Takaichi last week, Ueda said the premier seemed to have acknowledged the BOJ's plan to gradually raise rates to guide inflation smoothly toward its 2% target.
"The BOJ won't publicly admit so, but hiking rates can help stop yen falls," said Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management.
"There was no opposition voiced by Takaichi and Katayama over another BOJ rate hike, which also heightens the chance of a hike in December rather than January."
To be sure, there is uncertainty on whether the BOJ can pull off a December hike without antagonising Takaichi's reflationist advisers, who have warned of the dangers of a near-term hike.
Another complication comes from the Fed, which remains divided on whether to cut rates at its two-day meeting ending on December 10.
If the Fed holds steady on inflation worries or talks down future cuts, a subsequent dollar rise may weaken the yen and pressure the BOJ to hike next month.
Conversely, a Fed rate cut could support the yen and take pressure off the BOJ for an immediate response. But it would also raise questions about U.S. economic health and future BOJ hikes.
Still, the latest hawkish BOJ signals are enough to remind markets of the dangers of assuming the bank will keep interest rates low for long.
"You have markets that believe (Takaichi) will strong-arm the Bank of Japan into keeping rates lower for longer...(but) I am of the opinion that we will still see the Bank of Japan raise rates," said Kristina Hooper, chief market strategist at Man Group in New York.
"There is a real desire to normalise monetary policy."
(Reporting by Leika Kihara; additional reporting by Makiko Yamazaki and Yoshifumi Takemoto in Tokyo, Tom Westbrook in Singapore; Editing by Sam Holmes)
