By Leika Kihara
Oct 13 (Reuters) - The International Monetary Fund said on Tuesday the Bank of Japan will likely raise interest rates gradually "toward a neutral setting" despite an expected slowdown in growth, aligning with other central banks facing inflationary pressures.
"Growth in Japan is projected to slow to 0.7% in 2026, with fiscal support measures partly cushioning the impact from higher energy prices, and to stabilise at that level in 2027 as the energy shock dissipates and monetary policy
gradually normalises," the IMF said in its World Economic Outlook.
The growth forecast for 2026 follows last year's 1.2% expansion. The IMF expects Japan's economy to grow 0.7% in 2027.
The BOJ raised interest rates to a 31-year high of 1.25% in September and signalled its readiness to keep tightening policy to forestall the risk of inflation overshooting its 2% target.
Japan's heavy reliance on imports for fuel and raw materials makes its economy particularly vulnerable to the inflationary impact from the energy shock and a weak currency.
Without singling out any country, the IMF said monetary policy can look through the direct and short-term indirect effects on inflation "only if the shock is temporary."
Even where looking through the shock is deemed appropriate, central banks may need to raise nominal interest rates if inflation expectations heighten, to keep real borrowing costs steady, it said in the report.
The report also said exchange rates have experienced high volatility especially in Asia, prompting intervention by some countries, including a joint Japan-US operation to prop up the sagging yen.
"Maintaining orderly adjustment and financial stability is vital while large shocks are unfolding," it said.
While economies should allow exchange rates to move flexibly to absorb external shocks, currency intervention becomes an option if market moves are disorderly, the IMF said.
"Where (currency) depreciation becomes self-reinforcing, market liquidity evaporates, or currency movements threaten price stability through large pass-through or balance sheet stress, temporary foreign exchange intervention" can be considered, the report said.
(Reporting by Leika Kihara; Editing by Jacqueline Wong)
