The Bank of Japan raised its economic growth forecasts on Tuesday, but kept its policy stance unchanged, as was widely expected in its latest policy review.
The central bank raised its gross domestic product (GDP) forecast to 1.4 percent for the current fiscal year, from its previous forecast, made in October, of 1.0 percent growth. For fiscal 2017, it raised its economic growth forecast to 1.5 percent, from 1.3 percent, and for fiscal 2018, it raised its forecast to 1.1 percent, from 0.9 percent.
The BOJ said in a statement on Tuesday that it expected inflation to rise to around its target of 2 percent around fiscal 2018. It cited signs that medium-to-long term inflation expectations have stopped declining and were showing some indications of rising.
It also noted the labor market was tightening and that the effects of commodity-price declines were set to dissipate, with a pickup in international commodity prices set to push up consumer prices.
For the current fiscal year, it expected the consumer price index (CPI) excluding fresh food, its preferred indicator, would fall 0.2 percent, compared with its October forecast for a 0.1 percent fall, but in fiscal 2017, the BOJ expected inflation of 1.5 percent.
Analysts at DBS said in a note before the announcement that growth upgrades could be justified.
"Japan's exports and manufacturing have showed clear signs of recovery compared to a quarter ago, thanks to the improvement in the global economy, rebound in commodity prices and depreciation of the yen," DBS said.
The yen briefly strengthened after the decision, with the dollar fetching as little as 113.21 yen after the announcement, compared with as much as 113.73 yen shortly before the statement. At 11:35 a.m., the dollar was fetching 113.53 yen.
The BOJ decision followed some signs of improvement in the economy, but was likely tempered by uncertainty as the U.S., one of Japan's key trading partners, appeared set to pursue protectionist policies.
In its statement of risks, the BOJ mentioned developments in the U.S. economy and monetary policy, emerging market economies, particularly China, the consequences of Brexit and European debt issues as well as unspecified geopolitical risks.
The central bank had been widely expected to stay the course with its current yield-curve control policy, introduced at its late-September meeting.
The BOJ had set its target yield for the benchmark 10-year Japanese government bond at around zero percent. The BOJ has been willing to intervene to keep the benchmark yield in line with its target. In mid-November, the central bank offered a special bond buying operation, helping to boost bond prices and bring the benchmark's yield closer to its target.
That theoretically means the BOJ can buy fewer bonds as it would only need to time its purchases for when the yield curve moves away from its target. That would help ease concerns that the central bank, which already owns more than a third of all JGBs, would run out of bonds to buy as it continued with its planned 80 trillion yen (around $697.87 billion) annual pace of expansion of its monetary base.
The BOJ has taken essentially a "whatever it takes" stance on boosting inflation, saying it would maintain an easy stance until inflation exceeded its target of 2 percent "in a stable manner."
Japan's economic data recently has been mixed.
Industrial production grew 0.5 percent on-month in December, beating a Reuters poll forecast for a 0.3 percent rise, data released on Tuesday showed.
Capital Economics' senior Japan economist Marcel Thieliant noted that industrial output in the fourth quarter climbed 2.0 percent on-quarter.
"That's the strongest gain since immediately before 2014's sales tax hike and appears consistent with a sizeable increase in gross domestic product," Thieliant said in a note on Tuesday before the BOJ decision.
But household spending in December fell 0.3 percent on-year, slightly better than a Reuters poll forecast for a 0.6 percent fall, data on Tuesday showed.
Data released on Monday showed Japan's retail sales rose 0.6 percent on-year in December, below expectations from a Reuters poll for a 1.3 percent rise.
Inflation data released on Friday showed that core consumer prices, which include oil products but not volatile fresh food prices, fell 0.2 percent on-year in December, the slowest pace in nearly a year.
In the July-to-September quarter, Japan's gross domestic product (GDP) grew 1.3 percent on-year, according to revised figures released in early December.
While the BOJ has claimed Japan's economy has been booted out of a decades-long deflationary spiral, the central bank has had limited success in generating the desired levels of inflation.
Japan Prime Minister Shinzo Abe's program to boost the country's long-moribund economy out of decades of deflation, dubbed Abenomics, was introduced in 2013.
The program, which was expected to include three "arrows," began with a first arrow of massive quantitative easing from the Bank of Japan (BOJ). It was followed by plans for increased government spending. But the third arrow of structural reforms, including immigration and labor changes, has disappointed expectations.
One of Abenomics' efforts included boosting the nation-wide consumption tax to 8 percent from 5 percent, which took effect in April 2014, in a move aimed at improving government finances.
But that clobbered the economy as consumers stopped spending after the hike, forcing the government to postpone a second sales tax increase, potentially until 2019.
—By CNBC.Com's Leslie Shaffer; Follow her on Twitter