TOKYO, Oct 31 (Reuters) The Bank of Japan held rates unchanged, warned of heightened global risks and cut its growth and inflation forecasts on Wednesday but Governor Toshihiko Fukui stuck with his plan to gradually increase interest rates.
Fukui's somewhat hawkish tone, however, failed to alter a dominant market view that the next rate rise was unlikely until early next year.
The U.S. subprime crisis and market instability would not necessarily delay the next hike in rates from a current 0.5 percent, Fukui said, as it did not diminish the need to keep excessively easy monetary conditions from overheating the economy and distorting markets.
''Over-emphasising downside risks for the underlying economy and its immediate prospects could lead to policy mistakes,'' Fukui told a news conference after the BOJ reviewed rates and released a half-yearly outlook report.
In the report, the central bank said it now expected flat consumer prices in the year to next March, showing Japan had not yet won its struggle to escape deflation.
Financial markets showed minimal reaction to Fukui's remarks and to the widely expected policy ruling.
Swap futures on the BOJ's main policy rate still showed only around a 50 percent chance of a rate hike by next March -- which would be more than a year since the last hike.
''Fukui seems to be saying that the BOJ's standard scenario is still the main scenario and that the risks to the downside are still only risks,'' said Seiji Shiraishi, chief economist at HSBC Securities.
''But a heightening of risks was pointed out. I don't think they will raise interest rates at a time when they went out of their way to say risks are on the rise,'' he said.
The BOJ says it needs to raise rates gradually in line with improvements in economic and price conditions as keeping them at low levels for too long could lead to economic overheating.
The BOJ's decision to hold rates -- just hours before the Federal Reserve is expected to cut U.S. interest rates -- was by an 8-1 vote with former bond strategist Atsushi Mizuno alone for a fifth meeting in a row in seeking an increase.
CAUTIOUSLY OPTIMISTIC? In the outlook report, the BOJ cut its CPI inflation forecast for the year to March 2008 to 0.0 percent from 0.1 percent in the previous half-yearly report in April.
The central bank also said a soft landing in the U.S. economy was still likely but added further problems in the housing sector there posed downside risks to the Japanese economy.
''A disruption in overseas economic and global financial markets may adversely influence Japan's economy through, for example, changes in exports and imports, corporate profits and financial market conditions,'' the central bank said.
Recent Japanese data has done little to support the BOJ's view that tighter job conditions would push up wages, boosting personal consumption and consumer prices.
In September, core consumer prices marked the eighth straight month of annual declines, the jobless rate unexpectedly rose and wage earners' cash earnings, as well as summer bonuses, fell.
A sharp fall in Japanese housing starts due to tighter building rules is also seen slashing Japan's growth in the latter half of this year.
Housing starts fell 44 percent in September from a year earlier, government data showed, marking the biggest decline on record and the third straight month of drop after the rule change.
But the BOJ said in its report that, on average, the Japanese economy was likely to grow around 2 percent over the next couple of years, above what it saw as Japan's potential growth rate.
The BOJ last raised its benchmark rate in February, from 0.25 percent. A further increase to 0.75 percent this autumn had been seen as a near certainty before the U.S. subprime shock.
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