UPDATE 2-BOJ gov eyes risk of keeping low rates for too long

(For more stories on the Japanese economy click [ID:nECONJP]) (Recasts, adds analyst comments, more Shirakawa comments)

By Leika Kihara

OSAKA, Japan, Aug 25 (Reuters) - The Bank of Japan's head warned on Monday that central banks should be careful about the negative effects from keeping an easy monetary policy for too long and downplayed concern about a lengthy economic contraction in Japan.

While the world's second-largest economy faces the risk of a recession, many economists say Japan's low interest rates at 0.5 percent do not leave much room for the BOJ to boost the economy through further rate cuts.

BOJ Governor Masaaki Shirakawa told business executives in Osaka, western Japan, that the nation's economic growth will likely remain sluggish due to high energy costs and a slowdown in exports, but a deep adjustment is unlikely.

The government is set to compile an economic package this month to help businesses and individuals cope with high oil and food prices, which a senior ruling party lawmaker said could be worth 2-3 trillion yen ($18-27 billion). [ID:nT337029]

While expressing caution about Japan's economic outlook, Shirakawa reflected on past economic bubbles around the world and partly blamed excessively accommodative financial conditions for such bubbles.

"The current U.S. subprime mortgage problem keenly illustrates that it is difficult to recognise the bursting of a bubble as it happens," Shirakawa said.

"Central banks should therefore pay due attention, in their conduct of monetary policy, to the negative effects that may arise from prolonged accommodative financial conditions," he said.

Japan's overall financial conditions have been accommodative, Shirakawa said, adding that the nation's real interest rates were negative with the key policy rate standing at 0.5 percent, far below annual core consumer inflation of nearly 2 percent.

"Shirakawa touched on the risk of keeping interest rates low for a long period of time, so this means that he has no rate cut scenario in mind," said Hirokata Kusaba, a senior economist at Mizuho Research Institute.

"I think the BOJ will raise interest rates -- not cut them -- in the October-December quarter next year at the earliest providing that the Japanese economy bottoms out in the latter half of 2009."

RISK OF LOW RATES

The BOJ kept interest rates on hold at 0.5 percent as widely expected at a policy meeting last week. It also delivered a bleak assessment of Japan's economy, using language it has not employed since the Asian financial crisis.

In a statement announcing the rate decision last Tuesday the BOJ said the economy was "sluggish" -- a term it last used in its assessment in May 1998, when capital was fleeing Asia after an asset-price bubble collapsed the previous year.

Reflecting the gloomy outlook, many economists do not expect the BOJ to raise its key interest rate target to 0.75 percent until the final quarter of 2009 at the earliest. Many continue to forecast the next rate move to be a hike, not a cut.