The OECD stuck with a growth forecast for Japan this year of 1.6 percent, in a report issued on Monday, and repeated that the Bank of Japan should not raise interest rates until inflation is firmly on the rise.
The report comes at a time when Japan's economic outlook is clouded by worries about a global economic slowdown and jittery markets due to U.S. subprime housing woes, prompting some in the market to forecast the Bank of Japan will cut interest rates.
The OECD did not refer to a rate cut, merely sticking with a recommendation that the BOJ holds off hiking rates to avoid derailing economic expansion in the world's second-largest economy.
"The Japanese economy is experiencing the longest expansion in its post war history, and growth is projected to continue at a 1-½ to 2 percent rate over the next two years," the OECD said in the report that repeated its December forecast for 1.6 percent growth in 2008.
Japan's economy grew a surprisingly strong 0.9 percent in the last quarter of 2007, but economists expect growth to slow in 2008 amid fears that the U.S. economy -- Japan's No.2 trading partner after China -- is heading into recession.
Investors are pricing in around a 20 percent chance of a rate cut by June and a 50 percent chance of a rate cut by the end of the year.
The OECD also saw problems for the Japanese economy, but looked to more long-term issues than the credit crisis.
"Japan faces a number of challenges to sustained growth, most notably persistent deflation, a large and growing public debt and widening disparities between different segments of the economy."
Japan's industrial production, widely watched data that is seen key to the nation's growth outlook, has fallen in recent months as the subprime crisis has taken a toll on U.S. demand for Japanese goods.
Output fell 1.2 percent in February, government data showed last month, falling for the second month in a row.
The OECD forecast economic growth to speed up slightly to 1.8 percent in 2009 on the back of firm corporate investment and exports.
"Business investment is likely to continue to lead the expansion, given the overall high level of confidence, capacity utilization and profits," the report said.
The OECD, a club of 30 mostly industrialized economies, also recommended that Japan reform its tax system so that it promotes growth and addresses inequalities in incomes.
"Aspects of the tax system that discourage labor force participation and distort the allocation of capital should be removed, thereby accelerating growth," it said.
On the price front, the OECD sees the pace of inflation picking up gradually in the next two years.
The OECD expects Japan's core consumer prices, excluding food and energy, to fall 0.1 percent in 2008 but rise by 0.3 percent in 2009. The forecasts are unchanged from December.
If food and energy prices are included, inflation rates for 2008 and 2009 would be 0.3 and 0.4 percent, respectively, the OECD said.
The Japanese government's core consumer price index, which excludes fruit, vegetables and seafood, rose 1.0 percent in February from a year earlier, marking the sharpest rise in a decade.
The inflation rate was pushed up by higher oil prices and a series of price hikes in consumer goods in the face of rising raw material costs.
BOJ Should Not Hike For Now
The OECD said in the report that the BOJ should not raise interest rates until the risk of falling back to deflation is negligible.
The BOJ has sat tight on its monetary policy for more than a year in the face of market turbulence ensuing from the U.S. credit crisis and increasingly uncertain outlook for the economy.
It last raised its key overnight call rate by a quarter percentage point to 0.5 percent in February 2007.
The OECD said the BOJ should raise the lower end of its understanding of price stability from zero in order to have a adequate buffer against deflation.
The central bank is expected to release on April 30 a semi-annual report that includes its economic and price outlook for the current fiscal year, which started on April 1, and the next fiscal year.