Japan 2006 growth forecast trimmed to 2.7 pct -IMF

SINGAPORE, Sep 14 (Reuters) Japan's economy will grow 2.7 percent in 2006, a shade lower than previously forecast, but the country looks like it has emerged from a long-running battle with deflation, the IMF said on Thursday.

The International Monetary Fund said in its semi-annual World Economic Outlook that the Bank of Japan (BOJ) should focus on near-term monetary policy, eventually raising interest rates to more ''normal levels''.

But it said the central bank must take care to balance the risk of a return to deflation against the possibility of faster inflation.

''With actual inflation barely positive and estimates of trend inflation...just above zero, risks of a relapse into deflation in response to an adverse shock, such as substantial slowing in global growth, cannot be ignored,'' the IMF said.

The fund said prospects were favourable for low but steady inflation in 2006-07.

In mid-July, the BOJ raised its policy rate to 25 basis points after keeping it at zero for more than five years.

The IMF said Japan's expected 2.7 percent expansion this year, which is 0.1 percentage point slower than its April forecast, would be backed by domestic demand. Consumer confidence was riding high and household incomes are climbing, it said.

Growth will slow to 2.0 percent in 2007, the IMF said. In 2005, the economy grew 2.6 percent.

Japan remains vulnerable to external developments such as a further rise in oil prices, a softer U.S. economy or a sharp appreciation of the yen, the report said.

It added that the BOJ was right to err on the side of caution and raise rates gradually and it called on the central bank to define its medium-term inflation goals clearly.

The BOJ, which sees price stability at an inflation range of between zero to 2 percent, should allow the floor or the entire range to rise over time, the IMF said.

''A lower bound of zero for the range would leave open a risk that adverse disturbances could push the economy back into deflation.'' Even though Japan's economy grew at a slower pace in the second quarter, the IMF said Japan's recovery remained well-founded as private final domestic demand, the main driving force since 2005, has grown at a solid pace.

Private fixed investment is also buoyant, underpinned by robust profits and a turnaround in bank credit.

REUTERS VJ PM0820