TOKYO (Reuters) - Japan's central bank, facing the prospect of sharply weakening growth as soaring raw materials costs bite, gave up a two-year bias towards raising rates on Wednesday and warned downside risks dominated for the world's second-largest economy.
The glum outlook, delivered as the Bank of Japan decided to keep its interest rates at just 0.5 percent, the lowest among major G7 economies, helped send Japanese government bond futures soaring almost a full point.
"If we look at the prospects for 2008/09, we are putting more emphasis on downside risks than on upside risks," Governor Masaaki Shirakawa told a news conference.
For the first time in two years, the bank dropped from a half-yearly report on the economy its mantra of gradually "adjusting" Japan's low rates towards more normal levels.
The BOJ cut its growth outlook for the year to next March to 1.5 percent, from a previous 2.1 percent, and almost tripled its inflation forecast to 1.1 percent, up from 0.4 percent in its last half-yearly report in October.
The bank warned booming energy, food and other commodity costs posed risks to the economy along with turbulent markets and a faltering U.S. economy, which has curbed Japanese exports.
"Given the current situation where the outlook for economic activity and prices is highly uncertain, it is not appropriate to pre-determine the direction of future monetary policy," the BOJ said in the report.
The weakening economic outlook came as a string of new figures showed a sharp drop in Japanese industrial output and soft household spending, job vacancies and housing starts.
The jump in Japanese bond futures, boosted also by U.S. consumer confidence sinking to a five-year low, largely erased losses they suffered on Friday.
That rout had been caused by investors taking a view that the credit crisis was easing and central banks would face pressure to boost rates to combat rising inflation.
A Reuters poll on Wednesday, after the BOJ economic report, found traders and analysts still expected the next Japanese rate move to be a hike, but not until next year.
"The BOJ's outlook report was as expected, and the policy bias was brought to neutral from a tightening mode," said Joseph Kraft, head of capital markets in Japan for Dresdner Kleinwort.
"With this, any expectation for a rate hike was removed completely," he added.
Among problems for the Japanese economy is a risk that weakness in the United States will curb sales by major exporters that have been driving Japanese growth.
The U.S. Federal Reserve gives its verdict on interest rates later on Wednesday, with a cut of 0.25 percentage point expected but many expecting it to pause after that.
The downgrade in the BOJ's growth outlook followed the release of figures showing its industrial output fell 3.1 percent in March -- the biggest monthly fall for at least five years and far bigger than market forecasts for a 0.8 percent drop.
For a graphic of the data see: here
"This could raise concerns that the Japanese economy is slowing down sharply in the January-March quarter," said Yasuhide Takahashi, an economist at Nomura Securities.
"Output is also not expected to recover much in the coming months after a sharp drop in March. We think the economy will remain sluggish until the third quarter of this year."
Seasonally adjusted unemployment dipped to 3.8 percent in March, government figures showed. That was better than the flat 3.9 percent expected by economists, but they focused instead on a fall in the ratio of job offers to job seekers.
The ratio slipped to 0.95, meaning 95 jobs were available per 100 applicants, below a median forecast of 0.96 and continuing a fall from a peak of 1.07 last June.
"The trend shows hiring is slowing for the moment especially among small businesses, while big corporations continue to recruit new employees briskly," said Yoshiki Shinke, a senior economist at Dai-ichi Life Research.
Household spending fell 1.6 percent in March from a year earlier in price-adjusted real terms, countering a median market forecast for a 0.5 percent increase and further signaling weak consumer spending.
The weak U.S. data, and the U.S. rate review later on Wednesday, sent Treasuries higher.
Those moves, along with the weak Japanese figures, boosted the prices of Japanese government bond futures and interest rate futures, which have fallen sharply in the past week on worries about rising inflation.
June 10-year JGB futures rose 0.97 point, with traders also citing short-covering after Friday's big falls.
Until a few weeks ago, markets had been pricing in a cut in Japanese rates this year through swap contracts on the overnight call rate, but are now pricing in around a 60 percent chance of a rate hike by the end of the year.
While investors have ruled out a rate cut, Wednesday's data gave no comfort to anyone hoping for swift end to the effects of the credit crisis on Japan.
Housing starts, hit by a regulatory change last year, fell 15.6 percent in March from a year earlier, government figures showed, twice the fall the market had expected.
The NTC Research/Nomura/JMMA Purchasing Managers Index, which gives an early snapshot of the health of manufacturing, declined to a seasonally adjusted 48.6 in April, its lowest since 2003. A reading below 50 points to a contraction in manufacturing.
Additional reporting by Yoko Nishikawa, Yuzo Saeki and Masayuki Kitano; Writing by Rodney Joyce; Editing by Michael Watson