By Leika Kihara
TOKYO, May 13 (Reuters) - The Bank of Japan is projected to raise its short-term policy rate to 2% from 0.75% currently by the end of 2027, as robust domestic demand will help the economy absorb external shocks from the Middle East conflict, the OECD said in a report on Wednesday.
The assessment lends support to the BOJ's recent hawkish tilt ahead of its June policy meeting, with the Organization for Economic Co-operation and Development arguing that higher inflation expectations, solid
wage growth and a closed output gap justify continued rate hikes as Japan transitions away from decades of near-zero inflation.
The Paris-based body urged Japan to rely primarily on consumption tax hikes to boost revenues as the current rate, at 10%, is among the lowest in member economies.
Rising inflation initially reflected external factors such as higher commodity prices, but underlying pressures have since built as labour shortages drove up nominal wages, the report said.
"The Japanese economy is currently in a transitional period, shifting from three decades of near-zero inflation to an economy with rising prices and wages and growth supported by domestic demand," it said.
"While uncertainty from external headwinds warrants a cautious approach, the (BOJ's) interest rates should continue to be raised, given higher inflation expectations, solid nominal wage growth and a closed output gap," it said.
OECD expects Japan's economy to expand 0.7% in 2026 and 0.9% in 2027, slowing from an 1.2% increase last year.
Inflation will likely converge towards the BOJ's 2% target in 2026-2027 with robust domestic demand underpinning economic growth, it said.
The recommendations come as the BOJ gears up for another hike in its short-term policy rate from the current 0.75% with a recent slew of hawkish signals heightening the chance of action at its next meeting on June 15-16.
While the BOJ has left few clues on how far it could raise rates, its latest estimates showed Japan's natural rate of interest stood in a range of around -0.9% to +0.5%.
Assuming that inflation is 2%, the BOJ's current policy rate would be near the bottom end of the nominal neutral rate, the OECD said, adding the BOJ's policy rate is "projected to reach 2% by the end of 2027."
The OECD welcomed the BOJ's gradual reduction of Japanese government bond (JGB) purchases, part of efforts to wean the economy off its massive stimulus.
While the bond taper has improved market functioning, risks remain as the share of JGBs held by banks, insurance firms and pension funds has declined after years of low rates, it said.
"Going forward, the BOJ should stand ready to modify the pace and maturity profile of its purchases in case of disruptions to financial and bond market conditions," it said.
At the June policy meeting, the BOJ will review its bond taper plan running through March 2027 and lay out a new plan for April 2027 onward.
Some analysts have blamed slower BOJ bond buying for heightened volatility in the JGB market.
(Reporting by Leika KiharaEditing by Shri Navaratnam)
