Bank of Japan Governor Toshihiko Fukui pledged on Friday to keep monetary conditions loose, reinforcing market expectations that rates will stay low, even as government data showed inflation at its highest in a decade.
Fears that Japan could follow United States into a recession mean investors see more chance the Bank of Japan will cut its very low rates, currently at 0.5 percent, rather than raise them.
"In Japan, the underlying economy is slowing while a rise in the consumer price index is accelerating. But looking ahead, the economy will likely expand moderately under stable prices towards next fiscal year," Fukui told a parliamentary committee.
"Based on such judgment, we firmly believe that we can continue to realise stable economic growth by providing the current accommodative monetary conditions for a while."
Japan's core consumer price index, which excludes some volatile food prices, hit a decade high of 0.8 percent in the year to December, although this was mainly due to surging oil and other commodity prices, rather than a sign of a recovery in soft consumer spending.
Reinforcing the view that the central bank is more focused on economic risks, newly released minutes of the BOJ's December policy board meeting showed some members were concerned that international markets could remain unstable.
A sharp sell-off in Japanese stocks, down almost a third in six months, has boosted expectations of a rate cut, and Fukui acknowledged on Friday that the share price falls could further depress consumption.
"The near-term trend for the central bank is steady to lower policy," said Takehiro Sato, senior economist at Morgan Stanley Japan, adding that new policy direction may have to wait until after Fukui retires in March.
The downbeat assessment from Fukui came as U.S. lawmakers agreed on Thursday on a $150 billion economic package, boosting Wall Street and, in turn, Japanese stocks.
As well, investors saw less chance of a Japanese interest rate cut in the near term, with rate futures pointing to little chance now of a rate cut in February. They had implied a 20 percent chance a day earlier.
Rising energy costs and food prices have taken a toll on consumer sentiment. A Cabinet Office survey last week showed consumer confidence fell to a 4-1/2-year low in December.
The rise in the core consumer price index, which excludes fruit, vegetables and fresh fish but includes oil products, was the biggest since March 1998, when it rose 1.8 percent from a year earlier.
The BOJ said in a review of an half-yearly outlook report this week that core CPI growth in the current fiscal year to March 31 will likely be higher than projected last October due to rises in oil and food products.
But a soft patch in the economy is expected to partly cancel out the impact of higher oil and food prices in the next fiscal year, the BOJ said.
The central bank left interest rates unchanged on Tuesday, as expected, as turbulent financial markets and worries about a U.S. recession heightened fears about the economic outlook.