By Leika Kihara
Tokyo, July 22 (Reuters) - The Bank of Japan remains on alert to upside inflation risks that could lead to faster interest rate hikes than markets project, said three sources familiar with its thinking.
Many central bank policymakers believe the pace and timing of rate hikes cannot be pre-scheduled and they depend much on economic and price developments at the time, they said.
But some within the BOJ see scope to raise rates at a faster pace than the dominant market view of twice a year,
if price pressures from a weak yen and rising fuel costs from the U.S.-Israeli war on Iran push up inflation at a faster-than-expected pace, the sources said.
"Companies are passing on rising costs at a pretty steady pace and inflation expectations are heightening, which needs to be taken into account in setting policy," one of the sources said, a view echoed by another source.
The meetings in September and October could be live depending on the extent to which firms raise prices during the summer to pass on higher costs, a third source said.
The sources spoke on the condition of anonymity as they were not authorised to speak publicly.
The yen and short-term Japanese government bond (JGB) yields rose after Bloomberg News reported earlier on Wednesday that BOJ officials are open to raising rates at a faster rate than the consensus among economists.
The BOJ raised rates to a 31-year high of 1% in June. A Reuters poll, taken before the June decision, showed many analysts projecting the BOJ to take rates to 1.25% by the end of the year.
ATTENTIVE TO RISKS
The BOJ is set to keep its policy rate steady at 1% at next week's meeting, but will issue new quarterly projections that could offer clues on the timing of the next rate hike.
Sources have told Reuters the BOJ may revise up its growth forecast for fiscal 2026 and keep its focus on the risk of an inflation overshoot as rising costs from a weak yen and strong AI demand offset some of the declines in oil prices.
In the current report released in April, the BOJ warned of downside risks to growth and the chance of a sharp overshoot in inflation from its 2% target, which was blamed on the U.S.-Israeli war on Iran.
While both risks have subsided somewhat, the chance of an inflation overshoot remains as companies more swiftly pass on rising import costs from a weak yen, the sources said.
Robust global AI demand is also pushing up prices for metals and semiconductor chips, which in turn is likely to lift prices for a broad range of consumer goods, they said.
With underlying inflation already close to 2%, even modest inflationary risks would draw more attention in timing future rate hikes, the sources said.
The BOJ may face pressure to deliver a hawkish message at next week's policy meeting, with the yen hovering at a 40-year low partly on prospects that the U.S.-Japan rate divergence will remain large, analysts say.
While stressing that they do not directly target exchange rates in setting policy, BOJ officials have said they are watching yen moves carefully as the currency's declines more vividly affect inflation than in the past.
(Reporting by Gnaneshwar Rajan in Bengaluru; Editing by Muralikumar Anantharaman and Thomas Derpinghaus)
