TOKYO (Reuters) - Bank of Japan Governor Haruhiko Kuroda issued a strong warning on Thursday against easing up on fiscal discipline, stressing that the country can raise the sales tax and still keep the economy strong enough to put an end to grinding deflation.
His remarks came amid an intensifying political debate on whether Japan should proceed with a planned two-stage hike in the sales tax from next year, or opt for a more moderate rise to ease the pain on an economy just emerging from stagnation.
At a two-day rate review that ended earlier on Thursday, the BOJ kept monetary policy steady and held off on revising up its assessment of the economy, preferring to wait for more clues on whether increasingly positive data will encourage companies to ramp up spending.
While refraining to comment directly on whether Japan should go ahead with the tax hikes, Kuroda said that without efforts to rein in Japan's huge public debt, investors may sell government bonds en masse and push up yields to punishing levels.
"The BOJ is buying huge amounts of government bonds. This in itself is necessary to achieve our 2 percent inflation target," Kuroda told a news conference after the rate review.
"But if markets start to worry that Japan's fiscal discipline is loosening ... or that the BOJ is monetizing public debt, long-term interest rates may spike and reduce the effect of our quantitative easing," he said.
Prime Minister Shinzo Abe, who is wavering on whether to proceed with the scheduled tax hikes, has instructed the government to hold meetings with business leaders and academics later this month to assess the impact on the economy.
Economics Minister Akira Amari said a final decision would be made in late September through early October.
As widely expected, the BOJ maintained its policy launched in April of nearly doubling the monetary base to 270 trillion yen ($2.8 trillion) by the end of 2014 to end deflation and achieve its 2 percent inflation target.
A slew of positive data released since the BOJ's previous meeting had heightened expectations it may offer a rosier view of the economy to say more convincingly that it is recovering.
Core consumer prices rose for the first time in more than a year, summer bonuses increased for the first time in three years and the jobless rate hit a 4-1/2 year low.
Bank lending rose nearly 2 percent in July from a year earlier, the biggest increase in four years, data showed earlier in the day, boding well for the central bank's efforts to boost lending with its aggressive monetary stimulus.
But the BOJ decided to keep its assessment intact to say the economy is "starting to recover moderately," after upgrading its view in July for the seventh straight month.
Kuroda said that while the economy was gaining momentum, the nine-member board wanted to see more evidence that the initial positive signs on wages and capital expenditure are sustainable.
"We'd like to see clearer hard data (of improvements), particularly for capital expenditure," he said.
Many central bankers place a lot of importance on capital spending in gauging whether the huge amount of funds the central bank pumps out is reviving economic activity.
A survey by the state-backed Development Bank of Japan showed large companies planned to increase capital expenditure by 10.3 percent in the fiscal year that started in March, up from a 2.9 percent increase the previous year.
But shipments of capital goods, which help gauge the strength of capital expenditure, fell 12.1 percent in June after a flat reading in May, trade ministry data showed on Monday.
"The BOJ is more confident about the economy, but they are not likely to use more bullish language because we still need to support the economy with quantitative easing," said Hiroshi Miyazaki, senior economist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo.
"There's nothing to suggest the need for additional easing. Prices are doing better than expected and the BOJ looks more likely to meet its price target."
Indeed, the BOJ was slightly more optimistic on prices, saying that inflation expectations "appear to be rising on the whole" and core consumer inflation will likely accelerate.
Last month, it said there were some signs of heightening inflation expectations and that core consumer price growth will likely turn positive.
The BOJ will have more indicators to gauge the strength of the economy next week with Monday's release of second-quarter gross domestic product (GDP) data and Tuesday's machinery orders for June - a leading indicator of capital spending.
Japan's economy likely grew an annualized 3.6 percent in April-June to mark the third straight quarter of expansion, a Reuters poll showed, adding to signs the positive effect of Abe's reflationary policies is spreading.
($1 = 96.5850 Japanese yen)
Additional reporting by Tetsushi Kajimoto; Editing by Kim Coghill