BOJ keeps rates steady; focus on inflation

By Leika Kihara

TOKYO (Reuters) - The Bank of Japan kept interest rates on hold at 0.5 percent in a unanimous vote on Friday, as widely expected, as it balanced concerns about rising inflation with a worsening economic outlook.

While the BOJ, like other central banks, is worried about inflation from soaring raw materials costs, it sees little need to shift to a tightening bias for now as the economy is hardly overheating and inflation is not spreading much beyond food and energy prices.

Nevertheless, wholesale prices are rising nearly five times as fast as consumer inflation, squeezing companies that have led Japan's recent growth.

Investors are thus focusing on whether BOJ Governor Masaaki Shirakawa will join his counterparts in the United States and Europe in stepping up inflation warnings.

"The risk of stagflation is increasing with inflation accelerating even as the economy weakens," said Hideo Kumano, chief economist at Dai-ichi Life Research Institute.

"Shirakawa is faced with a difficult balancing act."

Comments by Shirakawa will be reported after a news conference expected to end by 4:30 p.m. (0730 GMT).

Rising commodity prices have swung the main focus of global policy-makers in recent weeks away from economic growth to the threat of a global spike in inflation.

Federal Reserve Chairman Ben Bernanke signaled this week that the U.S. central bank would act to strongly resist rising inflation, while European Central Bank President Jean-Claude Trichet said rates might rise as soon as July.

The global threat of inflation is also expected to take centre stage at this weekend's meeting of Group of Eight finance ministers, although measures to tackle it look elusive.

The hawkish remarks by Fed and ECB officials have heightened market expectations that the BOJ will follow in their footsteps and hike rates later this year, although many economists expect no action at least until early next year.

Derivatives are pricing in about a 95 percent chance of a Japanese rate hike by the end of this year, up from less than half earlier in the week. They are also pricing in a roughly 65 percent chance of two rate rises to 1.0 percent over the next year.

While the BOJ sees rising public awareness of inflation as a risk, a rate hike would become an option only if inflation expectations begin to feed on themselves and prices of a wide range of goods shoot up on strong demand, BOJ sources said.

The BOJ had been working towards "normalizing" rates in Japan, its parlance for raising the country's very low rates to more normal levels after nearly a decade of deflation.

But the U.S. subprime housing loan crisis has forced the central bank to take a more neutral stance lately.