By Leika Kihara
FUKUOKA, Japan, May 21 (Reuters) - The Bank of Japan should raise interest rates at an "appropriate pace" as price pressures from the Middle East war may push underlying inflation above its 2% target, board member Junko Koeda said, bolstering the case for a rate hike as soon as June.
The former academic also said the central bank must pay more attention to the side-effects of keeping real interest rates negative, as oil prices may remain high for a prolonged period.
"Given the situation
in the Middle East, I see some possibility that underlying inflation may exceed 2% looking ahead," Koeda said in a speech on Thursday, adding that recent rises in long-term inflation expectations warranted attention.
"I believe it's reasonable to raise the policy interest rate at an appropriate pace to address high inflation while also considering the trade-offs for the economy," she said.
Koeda said inflationary risks were already materialising and likely to be bigger than the risk of Japan suffering recession, as firms steadily pass on higher costs among each other.
"But there is still some time before our next policy meeting, so I would like to scrutinise whether the balance of risks could change or not," she told a news conference.
"The pace of future rate hikes will depend on economic, price and financial developments at the time," Koeda said, adding that she was focusing on the speed and magnitude of the pass-through from wholesale to consumer inflation.
The remarks suggest Koeda may join hawks in the board in calling for a rate increase, which would heighten the chance of a rate hike at the BOJ's next meeting on June 15-16.
The BOJ keeps its short-term policy rate at 0.75% even as core consumer inflation exceeds its 2% target for four years.
Koeda said the BOJ must be mindful of the demerits of keeping inflation-adjusted real interest rates well below levels deemed neutral to the economy, such as causing unintended distortions in future resource allocation.
Japan's wholesale inflation accelerated in April at the fastest pace in three years as the Iran war boosted oil and chemical goods prices.
Given Japan's positive output gap and strong global IT demand, Japan's economy is likely to avert a major economic downturn in coming years, Koeda said in her speech to business leaders in the southern Japanese city of Fukuoka.
"If the economy does not see a major downturn, more attention must be paid to the side-effects of a further decline in real interest rates," she said.
BIGGER ROLE FOR BOJ
Koeda's remarks follow those by another board member Kazuyuki Masu, who last week called for raising rates as soon as possible if there are no clear signs of an economic slowdown.
The recent slew of hawkish BOJ signals has led markets to price in roughly a 80% chance of a rate hike in June. Nearly two-thirds of economists polled by Reuters also expect the BOJ to raise rates next month.
At the April 27-28 meeting, the BOJ kept its short-term policy rate steady at 0.75%. But three board members dissented, instead calling for a hike in a sign of mounting concern over inflationary pressures from the Iran war.
If Masu and Koeda join the three hawkish dissenters, that means five in the nine-member board would favour a rate rise, and could outnumber doves preferring to keep rates steady.
Asked why she voted for keeping rates steady in April, Koeda said it was because there was uncertainty on the extent to which firms will pass on higher costs to consumers.
"There was also a significant risk our scenario could change sharply depending on Middle East developments," Koeda said. Now, however, there was a growing chance the conflict could keep oil prices elevated, she added.
"Developments over the past month or two may have increased the likelihood of a risk scenario in which high crude oil prices persist," she said, suggesting that the rise in energy costs stemming from the Middle East may not prove temporary.
Strong AI demand may also be contributing to higher energy prices, which could mean prices may increase across a wide range of items down the road, she added.
"Compared with the past, the role monetary policy must play in addressing inflation has increased," Koeda said.
The BOJ ended a decade-long, massive stimulus in 2024 and raised rates several times including in December on the view Japan was on the cusp of durably hitting its 2% inflation goal.
The Middle East conflict has complicated the BOJ's task, as higher energy costs fuel inflation while simultaneously squeezing an economy heavily dependent on oil imports.
(Reporting by Leika Kihara; Editing by Tom Hogue and Kim Coghill)
