Japan's revised down third-quarter growth on Friday, surprising markets that had expected an upward revision, prompting many to suggest it might now be late next year before the Bank of Japan can raise rates.
Soft capital expenditure saw gross domestic product (GDP) rise just 0.4 percent in July-September, revised down from an initial estimate of 0.6 percent growth and lagging the consensus forecast for a revision up to 0.7 percent growth.
"It's quite a bad number and shows Japan's economy is not in really good health," said Takeshi Minami, chief economist at Norinchukin Research Institute. "We expect the next Bank of Japan rate hike to come in July-September next year, but the timing may be delayed further."
The weak outlook for a rate rise boosted Japanese government bonds. Ten-year JGB futures rose 0.21 point to 136.66, recovering from a one-month low hit early in the day.
Many economists still expect Japan's economic expansion to continue well into next year and beyond, but they also say the risk is rising that the global credit crisis and a possible U.S. slowdown will interrupt Japan's export-led growth.
Financial markets expect the credit crisis in the United States and Europe to tie the hands of the BOJ, which has kept its key policy rate at 0.5 percent since February.
The central bank wants to restore ultra-low interest rates to more normal levels, to avoid the risk of overheating, but has been stymied by persistent deflation and worries about global growth.
Swap contracts on overnight call rates are pricing in just an 18 percent chance of a rate hike by March.
"The BOJ is pretty discouraged, not just by the GDP but other indicators," said Takehiro Sato, an economist at Morgan Stanley Japan. "It's going to be pretty tough for the BOJ to raise rates, at least for the first half of next year."
On an annualized basis, the economy grew 1.5 percent, much lower than a preliminary reading of 2.6 percent growth and economists' median forecast for a revision to a 2.7 percent increase.
"Given such uncertainties in the outlook, the Bank of Japan will continue to face difficulty in raising rates. We expect the next rate hike to come in October next year," said Tatsushi Shikano, senior economist, Mitsubishi UFJ Securities.
The downward revision was largely due to slowing capital expenditure growth, which was marked down to a 1.1 percent increase from the initial estimate for a 1.7 percent rise. Economists had forecast a upward revision to a 1.9 percent rise.
Private consumption, which makes up about 55 percent of the economy, rose 0.3 percent from the previous quarter, unchanged from preliminary figures.
So far, Japan's exports have showed no sign of slipping as a slowing U.S. economy is largely offset by strong growth in Asia and other developing regions.
Doubts are simmering, however, on whether Japan can continue to count on such a shock absorber.
Bank of Japan Governor Toshihiko Fukui acknowledged on Monday that if the U.S. growth slips far below 1.5 percent, the whole picture could look different.
Economists now expect the BOJ's tankan survey on Dec. 14 to show a small deterioration in Japanese business sentiment.
The BOJ has said it would need to raise interest rates gradually to prevent the economy from overheating in the long run.