By Leika Kihara
TOKYO, April 28 (Reuters) - The Bank of Japan is widely expected to hold off raising interest rates on Tuesday, but drop hawkish signals to leave itself scope to push up borrowing costs in coming months to counter inflationary pressure from the Middle East conflict.
The U.S.-Israeli war with Iran has complicated the BOJ's efforts to raise still-low interest rates gradually to levels deemed neutral to the economy, seen by markets at around 1.5%.
Markets are focusing on the BOJ's quarterly
outlook report and comments from Governor Kazuo Ueda for clues on how the protracted Iran war affects its rate-hike path.
At a two-day meeting ending on Tuesday, the central bank is widely expected to keep its short-term policy rate steady at 0.75% as fading prospects of a near-term end to the Iran war keep markets volatile.
Hawkish board member Hajime Takata may propose hiking the policy rate to 1.0%, though it is likely to be turned down by the board as had been the case in the past two meetings.
"Even if it were to keep rates steady this time, the BOJ is probably unwavering in its resolve to continue with further rate hikes," said Mari Iwashita, executive rates strategist at Nomura Securities.
"Governor Ueda will need to stress the BOJ's readiness to continue raising rates to avoid further declines in the yen."
Japan's heavy reliance on oil imports makes its economy vulnerable to the hit from surging oil prices and supply disruptions from the effective closure of the Strait of Hormuz.
But the risks of looking through the war-driven price pressure have increased as firms become keener to pass on higher costs including from a stubbornly weak yen, keeping inflation above the BOJ's 2% target for four years.
The slow pace of BOJ rate hikes has weighed on the yen and kept it near the 160-per-dollar that had triggered currency intervention in the past to prop up the sagging currency.
Unlike last year when higher U.S. tariffs forced a pause in its rate-hike cycle, the BOJ will stress its resolve to keep raising rates as the energy shock risks fueling broad-based inflation, sources have told Reuters.
The central bank may tweak its policy guidance pledging to raise rates "in accordance with economic and price improvements," to better communicate its willingness to act flexibly against inflation risks from the war, they said.
Nearly two-thirds of economists polled by Reuters expect the BOJ to raise its benchmark rate to 1.0% by end-June.
With surging fuel costs seen hitting corporate profits, the BOJ is set to cut its growth forecast for the fiscal year that began in April in its quarterly report, the sources said.
The board is also seen sharply revising up its fiscal 2026 inflation forecast with rising costs for oil-related raw material already prodding some firms to ponder price hikes.
In current forecasts made in January, the BOJ expects the economy to grow 1.0% in fiscal 2026 before slowing to 0.8% in 2027. It projects core inflation to hit 1.9% in fiscal 2026 and 2.0% in 2027. Next week's quarterly report will include forecasts for fiscal 2028 for the first time.
(Reporting by Leika Kihara; Editing by Sam Holmes)
