The Bank of Japan is seen cutting its growth and inflation forecasts and stressing more the downside risks, as markets push back still further into next year expectations of when the central bank will next increase rates.
The BOJ is expected to keep interest rates unchanged at 0.50 percent at its policy meeting on Wednesday, a few hours before the Federal Reserve is due to rule on U.S. rates.
The central bank is expected to reiterate in its half-yearly outlook report its stance that the economy is on track for modest but sustained growth and that rates need to rise gradually from current very low levels.
But the stance is becoming increasingly tough to sell as consumer prices keep edging lower and downside risks -- among them slowing U.S. growth and volatile financial markets -- have led markets to push back expectations of a rate hike.
"What the BOJ wants to do is to set a cautious tone on the economy but also signal that a rate hike is still in the cards," said Hideo Kumano, chief economist at Dai-ichi Life Research Institute. "The pace of any future rate hike, however, would need to be very slow given mounting uncertainties."
Markets now expect the BOJ to wait until March or later before raising rates. Swap contracts on the overnight call rate are pricing in less than a 20 percent chance of a BOJ rate rise by December, a 35 percent possibility for January and about a 60 percent chance for March.
Need To Go Slow
BOJ sources said the bank's nine board members were expected to cut their median economic growth forecast for this fiscal year below 2.0 percent, given a contraction in April-June and sharp falls in housing starts after regulations were tightened.
In the previous report issued in April, the board's median forecast was for gross domestic product to grow 2.1 percent this fiscal year, which ends next March 31.
The report may also highlight growing downside risks from overseas developments in light of lingering uncertainty over how U.S. subprime woes would affect markets and the U.S. economy, Japan's biggest export destination, economists said.
"The economy isn't in bad shape but isn't strong enough either for the BOJ to seriously debate the need of an imminent rate hike," said Izuru Kato, chief economist at Totan Research.
The board members' forecast for 2008/09 growth is seen left largely unchanged from the April projection of 2.1 percent, allowing the BOJ to stick to its view that the economy will continue expanding above its potential growth -- seen somewhere between 1.5 and 2.0 percent.
The BOJ has left its benchmark rate unchanged since February, when it raised it from 0.25 percent.
Markets had thought a hike to 0.75 percent this autumn was a near certainty before the U.S. subprime shock, which prompted the Federal Reserve to slash rates last month and possibly cut them again at a meeting ending on Wednesday.
Some economists say another Fed rate cut -- widely expected by markets -- could make it even harder for the BOJ to tighten credit, although BOJ officials have said policy decisions of other central banks would not affect their own.
Few Signs Of Inflation
Another headache for the BOJ has been soft consumer prices. The core consumer price index (CPI) fell 0.1 percent in September from a year earlier -- the eighth straight month of decline despite rising food and gasoline costs.
The main culprit has been soft wages, which have constrained consumer spending.
"The biggest disappointment for the BOJ must have been slow wage growth, more so than the subprime problem, as it cast doubt on its key scenario that corporate-sector strength will spill over to households," said Koichi Haji, chief economist at NLI Research Institute.
The BOJ, however, is seen maintaining its view that consumer price growth will pick up next fiscal year as tighter job conditions gradually push up wages.
The BOJ board's median core CPI projection for this fiscal year is expected to be cut to flat from the April forecast of a 0.1 percent rise. The median projection for 2008/09 is seen largely unchanged at 0.5 percent.
Aside from the semi-annual report, markets will scrutinize comments by BOJ Governor Toshihiko Fukui for his views on recent economic and market developments. His post-meeting news conference is scheduled for 3:30 p.m. local time Wednesday.