By Leika Kihara and Takahiko Wada
TOKYO, Sept 11 (Reuters) - The Bank of Japan is set to raise interest rates next week, most likely by 25 basis points, and may signal faster future tightening if price pressures heighten risks of an inflation overshoot, said four sources familiar with its thinking.
A hike to 1.25% would bring the BOJ's policy rate to levels unseen in 31 years. A rate hike just three months after its last one in June also suggests a faster pace of tightening, especially if the bank
raises rates again this year.
Many in the central bank see conditions falling into place for another rate hike with the economy on course for a moderate recovery and price pressure building, the sources said.
The BOJ also expects financial conditions to remain loose even if it were to take interest rates to 1.25%, said the sources, who spoke on condition of anonymity as they were not authorised to speak publicly.
While the yen's recent rebound could ease pressure on prices by moderating increases in import costs, the currency's past declines and a renewed surge in fuel prices will keep the BOJ on guard over inflation risks, they said.
"With underlying inflation so close to 2%, the BOJ needs to be extra mindful of upside price risks," said one of the sources, a view echoed by three more sources.
The BOJ raised interest rates to 1% in June and pledged to push up borrowing costs further if economic and price developments move in line with its baseline projections.
While it kept rates steady in July, the BOJ signalled a strong chance of a near-term hike by warning of the risk of an inflation overshoot due to price pressures from the Middle East conflict, a weak yen and brisk AI-related demand.
Analysts polled by Reuters expect the BOJ to hike rates to 1.25% at the September 17-18 meeting, 1.5% by end-March next year and then to 1.75% in the second quarter of 2027. Most saw the terminal rate as being at least 1.75%.
With markets having fully priced in a September hike, some market players had bet the BOJ could spur a surprise by going with a bigger-than-expected 50-basis-point hike.
With no immediate risk of an abrupt jump in wage and price growth, however, the BOJ will likely opt for the usual 25-point hike next week and await more data to gauge whether another near-term increase would be necessary, the sources said.
"Underlying inflation is about to reach 2%, but we don't see it sharply overshooting that level," BOJ board member Kazuyuki Masu said on Thursday, suggesting that he saw no imminent signs of a spike in inflation that warranted a big hike next week.
NO PRE-CONCEPTION ON TERMINAL RATE
Markets are focusing on any hints from Governor Kazuo Ueda's post-meeting briefing on the pace of future rate hikes and how far the BOJ could take rates under the current tightening cycle.
The BOJ likely has no preset idea on the terminal rate, which depends on how past rate hikes could affect the economy and the degree to which firms pass on rising input costs to households, the sources said.
There is also no consensus within the BOJ on how fast the BOJ should raise rates. The board is split between hawks, who see underlying inflation already having hit 2%, and doves like Toichiro Asada, who dissented to the June rate hike.
Ueda will thus avoid committing to a specific timeframe for future rate hikes, though he may repeat a comment made in July that the BOJ could speed up rate hikes if it deemed financial conditions as being too loose, the sources said.
After September, the BOJ holds a policy-setting meeting in October, December and then January next year.
Annual wholesale inflation hit 7.6% in August in a sign of mounting price pressure, which the BOJ predicts will push consumer inflation back above its 2% target in coming months.
In quarterly projections made in July, the BOJ expects core consumer inflation to hit 2.5% in the fiscal year ending March 2027 and 2.4% in the following fiscal year, before slowing to 2.0% the year after.
While the yen has gained more than 6% since the joint Japan-U.S. intervention in late July, the expected fall in import costs is being offset by a spike in Brent crude above $100 a barrel that raised fears of renewed inflation pressure.
(Reporting by Leika Kihara and Takahiko Wada; additional reporting by Takaya Yamaguchi and Tamiyuki Kihara; Editing by Sam Holmes)
