BOJ seen standing pat, door open for July hike

TOKYO, May 16 (Reuters) The Bank of Japan is expected to leave short-term interest rates pegged near zero as it draws down excess liquidity from the banking system, but to leave the door open for a rate increase as early as July.

Most economists expect the BOJ to maintain its current policy of keeping the overnight call loan rate effectively at zero after a policy-setting meeting on Thursday and Friday.

BOJ Governor Toshihiko Fukui's remarks earlier this month that the liquidity drawdown would be finished ''within several weeks'' fanned speculation that an interest rate increase could come as early as the following policy-setting meeting on June 14-15.

But Fukui played down such speculation this week, saying the central bank would not immediately raise short-term rates from zero after it finished absorbing excess funds.

Furthermore, he said on Monday, ''Finishing the reduction of the balance of current account deposits and exiting a period of zero interest rates are completely different issues.

''While we will look at movements in the money market to gauge the reduction of funds, interest rate levels will be determined by economic and price conditions.'' The funds surplus is the legacy of the BOJ's five-year-old ultra-easy monetary policy, which it ended on March 9. Fukui said at the time that it would take about three months to bring the balance of current account deposits down to around 6-7 trillion yen, the minimum required level of reserves, from a peak of 30-35 trillion yen.

The balance is now at about 15 trillion yen and is expected to fall to near 10 trillion yen by the end of the month, but market players say that could push money market rates higher.

Top BOJ officials said the drawdown of funds up to now has been ''as smooth as it can get'', but some said it was premature to begin discussing a rate increase as the road of drawing down the remaining excess liquidity could be bumpy.

Some analysts expect the BOJ to wait until September to raise rates.

''I don't see any sign from Governor Fukui that the BOJ is laying the groundwork for a rate rise in June or July,'' said Masuhisa Kobayashi, chief bond strategist at Barclays Capital in Tokyo.

DATA DEPENDENT The BOJ has stressed that a rate increase would depend on incoming economic data and developments in prices.

Gross domestic product data for January-March, to be released on Friday, is expected to show a sharp slowdown to around 1 percent annualised growth compared with 5.4 percent in the previous three months.

But the slowdown for the first quarter is widely expected, and the central bank will focus more on nationwide consumer prices for April, production capacity and firms' investment plans in the BOJ's June tankan survey to be released on July 3.

The BOJ is likely to use stronger wording to describe the outlook in this month's economic report, but is expected to leave its overall assessment unchanged until more immediate evidence of stronger economic data. The report will be released on Friday.

One snag in the BOJ's scenario to normalise interest rates may be a sharp dollar fall and an ensuing decline in stock prices.

The Nikkei share price average has lost some 5 percent over the past week, while the yen has strengthened nearly 10 percent against the dollar in the last month.

REUTERS PV GC1430