By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is set to keep monetary policy steady next week and maintain its optimistic view on the economic outlook, even as global trade frictions, growth worries and volatile markets put it further away from achieving its elusive inflation target.
A toxic combination of factors from escalating Sino-U.S. trade tensions to the fallout from U.S. interest rate hikes on emerging markets have stoked fears of a global economic slowdown and led to a shakeout in financial markets recently.
Worries over U.S. corporate earnings is causing further angst among investors, triggering a rout on Wall Street overnight that cascaded through to a global equities sell-off, effectively putting to test the BOJ's scenario that solid global demand will underpin Japan's export-reliant economy.
The biggest fear among Japanese policymakers is that the rising tide of protectionism and volatile market moves would hurt business sentiment and discourage firms from raising wages, thereby delaying achievement of the BOJ's price goal.
But many central bank policymakers believe such risks are not big enough now to alter their baseline scenario that Japan's economy will continue to expand moderately, say sources familiar with the BOJ's thinking.
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"Risks to the outlook are building up. But global growth and domestic capital expenditure remain strong," with few Japanese firms complaining of any direct hit from the trade frictions yet, said one of the sources, a view echoed by three other sources.
At a two-day rate review ending on Wednesday, the BOJ is widely expected to maintain a pledge to guide short-term interest rates at minus 0.1 percent and long-term rates around zero percent.
It is also seen roughly maintaining its growth and inflation projections in a quarterly review of its long-term forecasts.
In the current projection made in July, the BOJ expects core consumer inflation to hit 1.1 percent in the year ending in March 2019 and accelerate to 1.5 percent the following year.
After years of heavy asset buying failed to shock the public out of a deflationary mindset, the BOJ revamped its policy framework in 2016 to one that takes a longer-term approach in meeting its price target.
Under the current framework dubbed yield curve control, achievement of the inflation target is based on the assumption that solid global demand will support Japan's recovery long enough for companies to finally raise wages and prices.
That scenario is under threat due to increasing uncertainty over the global economy, which has prompted the International Monetary Fund to cut its estimate for world growth.
Some BOJ policymakers worry that exports may lose steam just when Japan's economy could also face strain on consumption from a scheduled sales tax hike in October next year.
While the government may pile pressure on the BOJ to fend off market shocks with additional stimulus, the central bank sets a high bar for doing so given its depleted policy ammunition.
The BOJ likely won't ease further unless a shock of the scale of the collapse of Lehman Brothers jolts the economy, the sources say.
Still, rising risks to the outlook could deter the central bank from debating an exit from ultra-loose policy any time soon, despite concerns among some BOJ board members about the mounting cost of prolonged easing, the sources say.
In a report analysing Japan's banking sector released on Monday, the BOJ said that risk-taking in the financial sector hit a three-decade high in a sign years of ultra-easy policy may be overheating some parts of the industry.
The warning underscored concerns among some in the BOJ that the protracted period of near-zero rates could hurt financial institutions' profits and discourage them from boosting lending.
"It's clear there is growing concern within the BOJ over the rising demerits of its policy," said Ryutaro Kono, chief Japan economist at BNP Baribas.
"But tightening policy before inflation makes a clear pickup would be conceding that its policy had failed," he said. "For the time being, there won't be any debate within the board on the next step (toward policy normalisation)."
(Reporting by Leika Kihara; Editing by Shri Navaratnam)
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