UPDATE 2-Japan econ weaker,world growth risks rise-BOJ Muto

(For highlights of Muto's remarks click on [ID:nT203374]) (Adds comments, details)

By Leika Kihara

SAPPORO, Japan Jan 10 (Reuters) - A leading contender to succeed Bank of Japan Governor Toshihiko Fukui said on Thursday Japan's economic slowdown was expected to continue for some time, reinforcing views that the central bank will wait at least until late this year to raise interest rates.

BOJ Deputy Governor Toshiro Muto, a former finance ministry bureaucrat who has rarely strayed from the bank's official line, also said downside risks to the global economy were heightening, although he reiterated that the central bank's next move would still be to raise interest rates, not cut them.

Surging raw material costs, sharp falls in Japanese housing investment and growing uncertainty in the global economy have led to a slowdown in Japan's economy, which had been expanding only modestly in the first place, Muto said.

"The positive cycle of output, income and expenditures is weakening temporarily," Muto said in a speech to business leaders in the northern city of Sapporo. "But I don't think the mechanism itself will break."

Muto told a news conference later in the day that the central bank has not fundamentally changed its main economic scenario of gradual economic expansion, and thus its basic monetary policy stance.

But he said the bank's scenario was based on a forecast of economic conditions, which was not immune to changes depending on how downside risks develop.

Financial markets' reaction was muted as Muto's remarks did little to change the widespread view that growing threats to Japan's economic outlook will keep the BOJ from raising its key policy rate from 0.5 percent until late this year or even next year.

But Japanese government bond futures hit a two-year high on Thursday, boosted by a slide in stocks and by expectations that the threat of a U.S. recession may prompt the Federal Reserve to keep cutting interest rates this year. [JP/]

"I think Muto presented some cautious views," said Susumu Kato, chief economist at Calyon. "But he also said there is no change in the BOJ's basic stance on monetary policy, that the BOJ will adjust interest rates as the economy steadily grows.

"He stressed downside risks to the economy, but that is in line with BOJ Governor Fukui, who mentioned those risks in November and December."

Fukui, whose term expires in March, has repeatedly said the BOJ needs to raise rates from current low levels to prevent a distortion in asset allocation from destabilising the economy.

The BOJ downgraded its economic assessment last month, the first such major downgrade in three years, saying growth was slowing.

But it has stuck to its view that rising output would boost household income and spending, keeping the economy on track for steady growth. This thinking has been the rationale for the BOJ in arguing that interest rates would need to be raised from current low levels.

BOJ SEEN SITTING TIGHT

The central bank has kept rates on hold since it raised them by a quarter percentage point to 0.5 percent in February, and many in the market see no BOJ move in the coming months.

A monthly survey by the Economic Planning Association, a Japanese government-affiliated body, showed on Thursday that a majority of economists expect the BOJ to keep rates on hold at least until July-September, with 21 of 33 who responded anticipating a rate hike during the third quarter. None saw a rate move by April.

Muto cautioned that sustained growth in the global economy, which was key for Japan's economy to move in line with the BOJ's basic scenario, was facing growing downside risks.

The U.S. economy was slowing further and conditions could worsen if prolonged adjustments in its housing sector begin to hurt personal consumption and capital expenditure, Muto said.

"Downside risks for the global economy are heightening as adjustments in the U.S. economy and global financial markets deepen," he said.

Economists at Goldman Sachs said in a note to clients on Thursday that Japan's tepid economy is in danger of following the United States into recession this year.

The probability of a recession in the world's second-largest economy was 50 percent, the report said, forecasting slow growth in the first half of the year as emerging market economies cool. (Editing by Mike Miller)