GLOBAL ECONOMY-Japan survey underlines growth concerns

TOKYO, June 19 (Reuters) - Business pessimism in Japan is spreading from manufacturers to the service sector, a Reuters survey showed on Thursday, reflecting weak domestic demand and the impact of rising prices for raw materials.

Although global policy makers have declared inflation a major threat, the Reuters tankan report highlights the dilemma they face in trying to combat rising prices without hammering growth.

Financial markets have scaled back expectations of aggressive central bank action to control inflation out of concern that the U.S. economy in particular is too weak. Data this week showed U.S. housing starts fell in May to a 17-year low.

Later on Thursday, the United States publishes leading economic indicators for May, which will provide further insight into the strength of the world's biggest economy.

The leading indicators index rose just 0.1 percent in April after declining for five months in a row. In May it is expected to show no change from the previous month.

The monthly Reuters tankan, designed to track the Bank of Japan's influential quarterly tankan report, showed sentiment among Japanese manufacturers remained negative, stuck at a five-year low in June.

Non-manufacturing sentiment turned negative for the first time in more than four years.

"Confidence is low among both manufacturers and non-manufacturers, so it shows the economy is declining more widely," said Yoshikiyo Shimamine, chief economist at Dai-ichi Life Research Institute.

"I think the BOJ's tankan will also produce pretty bad numbers. It will show that the economy is definitely entering a downturn."

RISKS

The non-manufacturing index fell 2 points to minus 2, while the manufacturing index held at minus 2. A result below zero shows most respondents in the survey, which was conducted between May 27 and June 16, were pessimistic.

For a graphic of the data click: here

The weak readings mean the BOJ tankan due out on July 1 will probably show a worsening of business sentiment from three months before, heightening expectations that the central bank will keep interest rates on hold at a low 0.5 percent this year.

BOJ Governor Masaaki Shirakawa reiterated the central bank's view on Thursday that Japan's economy was slowing due to the impact of rising energy and raw material prices.

"In this situation where uncertainty is extremely high, the BOJ will flexibly conduct policy by assessing risk factors," Shirakawa said in a speech at a meeting of Japanese credit associations.

Swap contracts on the overnight call rate show investors have scaled back their expectations of a 25-basis-point rate rise by the end of the year to roughly 60 percent JPONIBOJ=TRDT. Last week, markets were fully pricing in a rate rise this year.

INFLATION CONCERNS

Leading global policy makers have expressed increasing concern about rising prices in recent weeks.

U.S. Federal Reserve Chairman Ben Bernanke highlighted the need to keep inflation expectations under control, while European Central Bank President Jean-Claude Trichet said euro zone interest rates could rise in July.

South Korean President Lee Myung-bak declared inflation the gravest threat to the world economy since the oil shock of the 1970s.

Earlier on Thursday, the World Bank forecast China's inflation rate would jump to 7 percent this year, the highest level since 1996. [ID:nPEK138744]

And Switzerland's central bank raised its 2008 inflation forecast to 2.7 percent from 2.0 percent. [ID:nZAT007789]

Countering the growth concerns, British retail sales in May had their biggest monthly increase since the data series began in 1986. Analysts said the surprisingly strong figures would reinforce expectations that British interest rates would rise.

Policy makers around the world are concerned that by tightening monetary policy to control inflation, they could also kill off economic growth.

Japan's economy logged firm growth in the past two quarters but analysts have warned of a downturn this year on concern that deepening U.S. economic woes will spread.

Signs of weakness in the corporate sector led the BOJ to downgrade its view on exports and corporate profits in a monthly report last week.

The BOJ has kept monetary policy on hold since raising its key interest rate target to 0.5 percent in February last year. It abandoned its tightening bias in April and switched to a neutral stance due to heightened economic uncertainty. (Additional reporting by Tetsushi Kajimoto, Mari Saito; Writing by Neil Fullick; Editing by Alan Raybould)