By Leika Kihara
TOKYO, April 13 (Reuters) - Once seen as a strong possibility, a Bank of Japan rate hike in April is turning into a fainter prospect as fading hopes of an end to the Middle East conflict keep markets volatile and muddle the outlook for a fragile economy.
The protracted conflict has also heightened communication challenges for the central bank. Having laid the groundwork for a near-term rate hike with hawkish rhetoric this year, the BOJ now has fewer windows to signal to markets a pause
before its next policy decision.
The BOJ's April 27-28 meeting comes a week after the deadline of a fragile ceasefire between the U.S. and Iran that has failed to end Iran's blockade of the Strait of Hormuz.
BOJ policymakers are divided between those who focus on mounting inflationary risks, and others who prefer to wait to see how the conflict unfolds, say three sources familiar with its thinking. Also complicating the debate, the persistently weak yen continues to present a strong argument to hike, Japan's trade minister said on Sunday nL4N40V00C.
All of that suggests the decision would be a close call and heavily dependent on the yen and the fragile two-week ceasefire - much more risk than the BOJ usually deals with.
"It's up to how the BOJ balances upside risks to inflation and downside risks to growth, which is hard to judge with so much uncertainty surrounding the Iran war," one of the sources said, a view echoed by another source.
A third source said the chance of an April hike may have diminished given the risk the conflict could inflict stronger-than-expected economic damage.
"If the Middle East conflict persists and works to push down growth while accelerating inflation, it would pose a dilemma and difficult problem for us," BOJ Deputy Governor Ryozo Himino nL4N40S1YS said on Friday, adding the bank would focus on the scale and duration of the shock.
BOJ COULD STRUGGLE TO SIGNAL POLICY INTENT
Given the conflict's unpredictable nature, the BOJ may find it hard to drop clear hints on its rate decision, unlike in the past few meetings where executives offered advance signals to avoid surprising markets.
As a result, markets may see volatility regardless of whether the BOJ hikes rates or not in April, analysts say.
"If there's no additional hints from the BOJ, markets will start reducing bets of an April action. That means if it does hike, the move could surprise markets and push up bond yields," said Naomi Muguruma, chief bond strategist at Mitsubishi UFJ Morgan Stanley Securities.
"But keeping rates steady could also push up yields and weaken the yen on fear the BOJ is behind the curve in addressing inflation. So either way, markets won't take it very well."
Among the few events where the BOJ could drop hints would be a brief speech Governor Kazuo Ueda delivers on Monday, and his expected news briefing later this week after attending IMF and G20 meetings in Washington.
The governor may also speak on policy if summoned to parliament, though the dates are not set in advance.
TOUGH CALL
With inflation hovering around its target for nearly four years, the BOJ has been carefully laying the groundwork nL4N40B01Y for a near-term hike by highlighting mounting price pressures.
Ueda said in March nL1N407006 the central bank won't rule out raising rates again if the war-induced economic downturn proves temporary, keeping alive the chance of an April rate hike.
The BOJ then released a new gauge nL6N40E0AL showing underlying inflation exceeding its target, and a paper nL1N40I06M arguing that Japan is more prone to sustained inflation than in the past.
The signals, coupled with the hawkish tone of the BOJ's March meeting summary nL1N40I00A, led markets to price in a 60-to-70% chance of an April rate hike.
The BOJ has a strong case to push ahead with rate hikes.
Unlike its U.S. and European peers, its policy rate, at 0.75%, remains below levels deemed neutral to the economy. With inflation running around 2%, the BOJ risks overheating the economy by keeping real borrowing costs deeply negative.
Delaying rate hikes could also cause unwelcome yen falls that push up import costs and broader inflation. Trade Minister Ryosei Akazawa said on Sunday an April hike "could be among options" to support the currency as Japan's real interest rates remained quite low.
Proponents of an early rate hike point to the risk of higher oil costs driving up prices for a broad range of goods, adding to already mounting price pressures as companies more actively hike wages and pass on rising costs.
But the hawkish momentum is being challenged by fading hopes for an early end to the war with rapidly changing Middle East developments whipsawing markets and clouding the outlook for an economy heavily reliant on fuel imports from the Middle East.
While government subsidies have curbed fuel bills, recent surveys showed business nL1N40R05T and household nL1N40S05H sentiment worsened sharply in March. The BOJ's regional branch managers nL1N40P042 also warned last week of downside risks to growth.
Doves within the central bank fret that hiking rates amid deep uncertainty and market volatility could hit confidence, the sources said.
The longer the war persists, the bigger the risk of supply shortages that disrupt economic activity.
As a result, the BOJ is expected to cut growth forecasts and revise up inflation projections in a quarterly report due at the April meeting.
"The BOJ will probably raise rates again in April, June or July," judging from its recent hawkish communication, said former BOJ board member Seiji Adachi.
"But whether it hikes in April would be a tough call, as doing so would mean pulling the trigger when the economic impact of the war remains unclear."
(Reporting by Leika Kihara; Editing by Sam Holmes)
