Bank of Japan raises rates to 31-year high, flags more to come

By Leika Kihara and Makiko Yamazaki

TOKYO, June 16 (Reuters) - The Bank of Japan raised interest rates to a 31-year high on Tuesday in a landmark step in its policy normalisation, signalling readiness to tighten further as it focuses on taming price pressures from the Iran-war-induced energy shock.

The hike was the first since December and aligns the BOJ with other central banks shifting towards tighter policy to combat inflation, including the European Central Bank.

Deputy Governor Shinichi Uchida indicated the BOJ would continue to raise rates, focusing on the risk of inflation deviating upward from its 2% target despite an easing of immediate economic risks tied to the Iran war.

While acknowledging the recent U.S.-Iranian peace deal as a welcome move, he noted persistent price pressures as firms become more active in passing on costs and raising wages.

"With underlying inflation approaching 2%, we need to be mindful of upward price risks. We will guide policy so that we won't fall behind the curve," Uchida told a news conference he held on behalf of Governor Kazuo Ueda, who missed the meeting for medical treatment.

In a widely expected move, the BOJ raised its short-term policy rate to 1% from 0.75%, taking borrowing costs to levels unseen since 1995.

"Taking into account that medium- and long-term inflation expectations have also continued to increase, there is a risk of underlying inflation deviating above our price target," the BOJ said in explaining the move.

The decision was made by a 7-1 vote. Toichiro Asada, who was hand-picked by dovish premier Sanae Takaichi, dissented.

"It's quite striking the BOJ mentioned so clearly that underlying inflation could deviate upward from its target," said former BOJ official Nobuyasu Atago.

"It's essentially saying there is a real risk of being behind the curve. There's a chance the BOJ could hike rates sooner than the dominant market view of a December action."

Still, Japan's Nikkei share average rose to a record high as investors saw the BOJ in no rush to raise rates again. The yen remained largely flat at around 160 per dollar, a level traders view as a line in the sand for Tokyo's currency intervention.

"Uchida was as always, clear and stable. His remarks left no room for error, leaving FX markets with no opportunity to engage in speculative trading," said Shigeto Nagai, head of Japan economics at Oxford Economics in Tokyo.

The BOJ also decided to pause its bond taper programme from April next year and continue to buy roughly 2 trillion yen ($12.5 billion) in Japanese government bonds (JGB) per month.

It will discontinue its practice of conducting a yearly review of its bond taper plan, but stands ready to amend the pace of purchases if necessary at future policy meetings.

ANOTHER HIKE EYED

The Middle East conflict has complicated the BOJ's policy path by adding inflationary pressure through higher oil costs, while hurting an economy heavily reliant on imported fuel.

The peace deal between the U.S. and Iran eased market fears over global inflationary pressures, but wholesale inflation spiked to a three-year high of 6.3% in May in a sign companies were already passing on higher costs from the energy shock.

A weak yen, which pushes up import prices and broader inflation, will also keep the BOJ under pressure to stay on course for further rate hikes, analysts say.

The BOJ said the risk of Japan's economy deteriorating sharply from the Middle East conflict has diminished due to progress in procuring alternative energy supplies.

The price outlook, on the other hand, warranted attention as companies were seen passing on rising oil costs to each other at a "relatively fast pace," which could push up consumer prices across a wide range of items, it said.

While offering few clues on the timing of the next rate increase, Uchida said the BOJ's near-term focus was on upward price risks with underlying inflation already close to the BOJ's 2% target.

The BOJ was also closely watching yen moves as firms are more swiftly passing on import costs than before, he said.

"Uchida appeared to signal the BOJ was shifting the focus of its policy on inflationary risks," said Mari Iwashita, executive rates strategist at Nomura Securities.

"If inflation overshoots around summer, the BOJ could hike in October. If not, it may wait till later. One thing is clear, which is that it will definitely hike again by year-end."

($1 = 160.2100 yen)

(Reporting by Leika Kihara and Makiko Yamazaki; additional reporting by Satoshi Sugiyama, Kantaro Komiya and Rocky Swift; Editing by Sam Holmes and Jacqueline Wong)