Highlights 2-BOJ's Shirakawa says Japan not in stagflation

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TOKYO, July 15 (Reuters) - Bank of Japan Governor Masaaki Shirakawa said on Tuesday he does not think Japan has entered stagflation.

He also said Japanese financial markets remain relatively stable even after U.S. financial markets were hit by renewed concerns over the health of U.S. lenders.

Following are highlights of his comments at a news conference.

MONETARY POLICY

"We need to bear in mind that there is a considerably long time lag before the effect of monetary policy appears (in the economy). There are various views about the length of the lag but it is said to be about one-and-a-half to two years.

"Therefore, we determine current interest rate levels with an eye on the outlook for the economy and prices one-and-a-half to two years ahead.

"The economy is slowing further and will continue to do so for a while, but will then gradually return to a moderate growth path. Prices are rising but the pace of increase will likely slow after a while. Based on this assumption, there is no need to adjust rates at the moment.

"That said, the economy and prices are faced with risks in different directions. We will take this into account and conduct policy by examining at each policy meeting whether there is any change to our scenario."

JAPANESE ECONOMY

"Business sentiment is becoming more cautious, as seen in the tankan survey. Many of the BOJ's regional branch managers who gathered (for a meeting last week) said growth was slowing further.

"The possibility of the economy remaining on a sustainable growth path with price stability is relatively high. In that sense, I don't think Japan has entered a phase of stagflation.

"Having said that, there is high uncertainty over such an outlook. We are in a stage where we need to carefully watch both downside risks to the economy and upside risks to prices."

"The biggest factor behind the current slowdown is a further deterioration in terms of trade. Corporate earnings have been suppressed, which affects capital spending. Although capital spending of big manufacturers has remained firm, that of small firms and non-manufacturers is more clearly slowing.

"Consumption is also sluggish, hit by both tame wage growth and worsening terms of trade."

"Production is in a declining trend, although the margin of fall is not that big."

JAPAN INFLATION

"The view that growth in the global economy, particularly emerging economies, will likely continue is behind the current rally in oil prices.

"In this midterm review, we've assumed that commodity prices will remain at a high level, in another word, we are not assuming they will keep rising continuously nor will they fall sharply from here."

"I don't see any second-round effects (in Japan), which would be rising crude oil prices boosting inflation expectations and affecting wages.

"But surveys have shown that household inflation expectations are edging up ... So we need to carefully watch whether there would be any second-round (inflation) effect in the future."

U.S. ECONOMY

"The Federal Reserve's forecast is for U.S. growth to pick up gradually from late 2008 to 2009, but I feel the timing is being pushed back a bit. Most (BOJ) board members' view today was that they needed to be somewhat more aware of downside risks to that standard scenario."

JAPAN'S FINANCIAL SYSTEM

(Asked about banks' exposure to U.S. agency bonds)

"I'd like to decline to comment on the details of the BOJ's investment in foreign assets."

"I understand that Japanese banks, centring on big ones, hold (Fannie Mae and Freddie Mac) bonds. We'll carefully monitor their investment in these securities and other credit products."

"I'm paying more attention to how the issue will affect Japanese markets than to Japanese banks' direct exposure to U.S. assets. I'm watching bonds, credit and stock markets ... Having said that, so far, Japanese financial markets have not been shaken by major turmoil, even though there have been some marginal changes that are not directly linked to the latest problem in the United States."

JAPAN'S REAL INTEREST RATES

"Japan's real short-term interest rates are at a very low level. The overnight call rate is 0.5 percent while consumer prices, excluding fresh food prices, are rising at 1.5 percent. That means, in a simple calculation, real interest rates are at minus 1.

"Japan's potential growth rate is seen as somewhere around 1.5 percent to 2 percent. That means current real interest rates have a potentially big stimulating impact on the economy. The impact has not been visible now due to various downside factors for the economy.

"But if those downside factors disappear, the potential power (of real interest rates) will be brought into play. When you look at the world economy and markets since 2003, interest rates were kept low as inflation was not that high even when economic growth was strong. That helped build up various imbalances.

"As the case in 2003 shows, we as a central bank must be mindful of the risk of such imbalances building up over a long period of time. But that doesn't mean it has any implication on our underlying monetary policy." (Reporting by Hideyuki Sano, Leika Kihara, Tetsushi Kajimoto)