By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) - The Bank of Japan is likely to keep its bullish inflation outlook even as it cuts its economic growth forecast for this fiscal year in an October report, sources said, suggesting that the bank will not ease policy further at least until the end of 2014.
But central bankers are hardly complacent as they remain concerned about the outlook for exports, a soft spot in the economy that has failed to pick up despite the boost from a weak yen that gives Japanese goods a competitive advantage overseas.
Japan's government kept its economic assessment unchanged at its monthly report on Tuesday, saying the world's third largest economy is "expected to recover moderately" as the effect of a sales tax hike in April eases gradually.
But it turned slightly more cautious about factory output, which in June posted its biggest decline in more than three years due partly to weak overseas demand.
Japan's economy contracted a hefty 6.8 percent in the second quarter due largely to the tax-hike pain, prompting many private-sector analysts to downgrade their growth forecasts for the year ending in March to around 0.5 percent, just half the 1.0 percent expansion estimated by the BOJ in July.
The central bank is seen cutting its GDP estimate for the current fiscal year, which ends in March, when it next updates its economic and consumer price forecasts in a semi-annual review on Oct. 31. But any downgrade will be minor and unlikely to greatly affect its bullish projections for inflation to climb near 2 percent next fiscal year, people familiar with its thinking say.
BASIC SCENARIO STAYS
"The basic scenario of a moderate economic recovery pushing up inflation remains in place," one of the people said on condition of anonymity.
The downgrade in its economic estimate would be largely due to the sharp contraction in second-quarter GDP, although many BOJ officials remain optimistic that growth will rebound from the current quarter as the tax-hike effect begins to ebb.
In a statement to be issued at a rate review next week, the BOJ is likely to say the economy is recovering moderately with the tax-hike impact "gradually beginning to subside", signaling its relief that consumption is holding up even as households feel the pinch from the higher levy, the sources said.
That will be a slightly rosier view than the current assessment that the economy is recovering moderately, albeit with some speed bumps caused by the tax hike.
It will also be more optimistic than a warning made in Tuesday's government report that the tax hike could have prolonged effects on the economy.
BOJ Governor Haruhiko Kuroda said earlier this week that consumption is "back to normal levels now" and that he expected a recovery in GDP in July-September.
SOME RISES IN INCOME
Behind the BOJ's optimism lies a steadily improvement in job and household income conditions. Regular pay rose 0.2 percent in the year to June, marking the first increase in more than two years, and summer bonuses were up 2 percent, easing some of the pain from the higher tax.
The BOJ hopes that such increases in wages, driven by a tightening job market, will support household spending and encourage companies to raise prices of goods and services. That, in turn, will allow Japan to meet the BOJ's 2 percent inflation target next fiscal year, central bank officials say.
But a lack of pick-up in exports remains a key concern for many central bank policymakers. They worry that the economic recovery may falter if companies do not see an increase in overseas shipments, as that is needed to make up for the slowdown in domestic demand.
Exports rose in July for the first time in three months in a tentative sign that overseas demand is starting to recover, but probably not enough to nudge the BOJ into reviewing its assessment that exports are "weakening," the sources said.
The BOJ is widely expected to keep monetary settings intact at its next rate review on Sept. 3-4 and scrutinize a slew of indicators out this Friday, including July's factory output and consumer spending figures that will likely show an uninspiring recovery from the sting of April's tax hike.
(Additional reporting by Sumio Ito and Yoshifumi Takemoto; Editing by Richard Borsuk)