The Bank of Japan said yesterday that it expects the world's No.2 economy to break decisively out of deflation by next year as it upgraded its forecasts to show 1.8 percent growth in the year to March 2007.
In its twice-yearly economic outlook, the central bank said the chances of a change to its expansionary monetary policy were likely to increase from April.
But it said interest rates would remain "very low" for a period after the first change to its policy, under which it floods the financial system with cash to try to stem consumer price falls and stimulate growth.
The world's number two economy has been caught in the grip of deflation for more than seven years but is now on the road to recovery after a decade-long slump seen since Japan's "bubble economy" burst in the early 1990s.
The Bank of Japan says it is close to winning its long battle with deflation, which is considered damaging for an economy because it deters individuals from spending today rather than tomorrow and hits company profits.
The central bank now expects consumer price changes to reach zero or turn positive toward the end of this year.
It sees a rise in core consumer prices of 0.1 percent in fiscal 2005, which ends in March next year, compared with a decline of 0.1 percent previously forecast.
Inflation is now expected to pick up to an annual pace of 0.5 percent in the fiscal year 2006 compared with an April forecast of 0.3 percent.
The Bank of Japan has vowed to continue to pump cash into the economy until deflation gives way to mild inflation as part of its near-zero interest-rate policy, which it left unchanged yesterday.
Based on its forecasts, the central bank said the possibility of a change to the present monetary policy framework was "likely to increase over the course of fiscal 2006."
But the Bank of Japan said it would be in no rush to raise interest rates after it changes its current policy of making funds of ?30 trillion to ?35 trillion (US$260 to US$300 billion) available to banks.
The report predicted "a period of very low short-term interest rates followed by a gradual adjustment to a level consistent with economic activity and price developments."
The central bank also raised its forecasts for GDP growth to 2.2 percent in fiscal 2005 from 1.3 percent previously, and to 1.8 percent in fiscal 2006 from 1.6 percent.
"Japan's economy continues to recover, having emerged from the temporary pause that began in the second half of 2004," the report said.
Overall economic activity had been more robust than predicted in April thanks to unexpectedly strong domestic private demand which more than offset lower-than-expected exports, it added.
The adjustments in production and inventory in technology-related sectors, which caused the economy's soft patch last year, appear to have run their course, the central bank said.
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