By Leika Kihara

WASHINGTON (Reuters) – The Bank of Japan is set to maintain ultra-low interest rates next week, likely signaling a less dovish policy outlook due to receding fears of U.S. recession and the need to prevent excessive depreciation of the yen.

Since the end of its radical stimulus program in March, the BOJ has indicated its intention to gradually raise interest rates from historic lows. However, after a rate hike in July, which prompted market turmoil, it chose to temper its hawkish stance, vowing to proceed slowly or even pause future hikes.

Despite appearing in no hurry to adjust rates, any shift towards a less dovish approach could reflect the BOJ's intention to retain flexibility regarding future decisions, according to analysts. This measure may also be aimed at preventing further depreciation of the yen, which has recently declined, potentially increasing the import costs of fuel and food and negatively affecting consumer spending.

"As the yen is falling again, the BOJ will probably try to avoid a message that seems too dovish," said Ryutaro Kono, chief Japan economist at BNP Paribas.

At the two-day meeting concluding on October 31, the BOJ is expected to maintain short-term interest rates at 0.25%. Following this meeting, a quarterly report is anticipated, likely with no significant change to its inflation projection, which is expected to hover around 2% until early 2027.

Recent data suggest that increasing wages and expectations of sustained salary growth are supporting consumption, prompting more businesses to raise prices for both goods and services. An ongoing labor shortage is also fueling expectations for continued wage increases next year, according to sources familiar with the BOJ's perspectives.

"Japan's economy is on track for a recovery," one source noted. "Prices will likely keep rising as many companies have yet to fully pass on rising costs," another added.

The BOJ may reflect on this positive development in its report, reinforcing its belief that conditions for further rate hikes are beginning to align.

STRIKING THE RIGHT BALANCE

However, market participants will closely scrutinize the BOJ's assessment of risks, as Ueda cited unstable markets and U.S. recession fears as key reasons for a cautious approach to rate increases. After meetings with global economic counterparts in Washington, Ueda expressed a cautiously optimistic view on the global economy.

"Optimism over the U.S. economic outlook appears to be broadening somewhat," he stated, although he noted that more scrutiny was necessary to determine if this sentiment is long-lasting.

The BOJ may also consider updating the policy guidance section of its report. In its July document, the BOJ stated it would continue rate hikes if economic and price conditions aligned with its forecasts. The board may debate whether to introduce additional language regarding risks or conditions for future policy shifts, sources reported.

The BOJ ended its negative rates in March and raised short-term rates to 0.25% in July, reflecting progress towards sustainably meeting its 2% inflation goal. Ueda has reiterated that the BOJ will continue raising rates if the economy aligns with its expectations, but emphasized a lack of urgency, as inflation remains moderate.

A slight majority of economists surveyed by Reuters expect the BOJ to refrain from a hike this year, though most predict one by March. On Thursday, the IMF praised the BOJ's July rate hike and encouraged the central bank to proceed with gradual rate increases.

Nevertheless, political uncertainty and the yen's ongoing decline complicate the BOJ's communication strategy. The bank aims to be cautious to avoid disrupting markets, while fears of sounding overly dovish could incentivize speculators to sell off the currency — a challenge Ueda acknowledged in Washington.

"When there's huge uncertainty, you typically want to move slowly and carefully. However, if you proceed too gradually and foster expectations that low rates will be maintained for an extended period, this could lead to a problematic accumulation of speculative positions," Ueda told an IMF panel on Wednesday.

"We need to strike the right balance."