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BOJ's Iwata Issues Cautious Note on Japanese Economy

Bank of Japan Deputy Governor Kazumasa Iwata struck a cautious tone on Japan's economic outlook, saying on Thursday that the central bank needs to adjust interest rates by closely examining risks, among them soft stock prices and a higher yen.

While offering few clues on the timing of the next rate hike, Iwata, regarded as somewhat dovish on monetary policy, stressed various downside risks for Japan's export-driven economic recovery, among them the increased chance of a further U.S. economic slowdown and still jittery financial markets.

"We need to be aware that stock price falls and the yen's rise, if sustained, could have a negative effect on Japan's economic outlook," Iwata said in a speech to business leaders in Shimonoseki, southwestern Japan.

Financial markets did not react much to Iwata's remarks as they did little to clarify whether the BOJ will raise its key policy rate by the end of this year, or wait until next year to allow more time to assess the economic fallout from the U.S. subprime woes.

"Iwata was cautious as expected as he underlined the point that uncertainty was heightening over the outlook for the U.S. economy," said Naomi Hasegawa, senior fixed income strategist at Mitsubishi UFJ Securities.

"Basically, Iwata was repeating what (BOJ Governor Toshihiko) Fukui said at a news conference last month. The BOJ takes it that uncertainty stemming from the subprime woes is growing over the financial market turmoil and a slowdown in the U.S. economy," she said.

The BOJ is widely expected to keep interest rates unchanged at its policy meeting next week, as central bankers assess any economic fallout from the U.S. subprime mortgage market.

The central bank has kept its benchmark rate unchanged since February, when it raised it to 0.5% from 0.25%. Iwata was the sole dissenter in the February decision to tighten credit, calling instead to keep rates steady.

U.S. Outlook Uncertain

Iwata said adjustment in the U.S. housing sector could last longer than initially expected, heightening the chance that U.S. economic growth will stay below its potential for another year.

While the U.S. economic slowdown has had limited impact on exports so far, Japan's economic growth may be hurt if U.S. growth slows further and European economies soften amid the global market turmoil, he said.

"We need to carefully check the outlook for Japan's capital spending, consumption, wages and prices given the external environment," Iwata said.

Markets had initially thought a hike to 0.75% this autumn was a near certainty, given the central bank's pledge to raise rates gradually in line with improvements in economic and price conditions.

But the global shockwave from the U.S. subprime problem has made even a rate hike by the end of the year a close call, with markets divided over whether the next increase would come this year or early next year.

Japan's economy, the world's second largest, contracted slightly in the April-June quarter on weak capital spending, but economists expect it to rebound in the July-September quarter.