By Leika Kihara and Makiko Yamazaki
TOKYO (Reuters) -Japanese big manufacturers' sentiment improved slightly in the three months to December, a quarterly survey showed on Friday, boding well for the central bank's plans to gradually raise interest rates from near-zero levels.
Non-manufacturers also remained upbeat on business conditions, though concerns over rising raw material and labour costs weighed on retailers' morale, the survey showed.
The data released ahead of the Bank of Japan's two-day policy meeting next week highlights how an intensifying labour shortage is becoming a headache for companies and a potential constraint to economic growth.
Companies expect business conditions to worsen over the next three months, the BOJ's "tankan" survey showed, as soft global demand and threats of higher tariffs from U.S. president-elect Donald Trump cloud the outlook.
The headline index measuring big manufacturers' business confidence stood at +14 in December, up from +13 three months ago and marking the highest reading since March 2022, the survey showed. It compared with a median market forecast for +12.
The improvement was due largely to a rebound in auto production and robust demand for equipment as companies ramp up capital expenditure, a BOJ official told a briefing.
"Companies seem to be weathering headwinds from China's economic weakness. This is good news for the BOJ and shows things are on track for the economy and prices," said Saisuke Sakai, chief economist at Mizuho (NYSE:MFG) Research & Technologies.
An index gauging big manufacturers' sentiment declined slightly to +33 from +34 in September, compared with a median market forecast for a reading of +32.
The business mood worsened sharply among retailers, hotels and restaurants as they struggled to hire staff, and faced rising labour and raw material costs, the survey showed.
"Demand from inbound tourism remains strong but may be peaking, while households may be becoming more frugal," said Kazutaka Maeda, an economist at Meiji Yasuda Research Institute.
Big companies expect to increase capital expenditure by 11.3% in the fiscal year ending in March, higher than a 10.6% gain projected in the previous survey in September. The increase was bigger than market forecasts for a 9.6% rise.
Small non-manufacturers' sentiment improved to levels last seen in 1991 as the pass-through of rising costs lifted profits, the survey showed, a sign Japan is seeing signs of sustained price rises - a prerequisite the BOJ set for further rate hikes.
Companies expect inflation to stay above the BOJ's 2% target one, three and five years ahead, the tankan showed, suggesting that conditions for raising Japan's still-low interest rates were falling into place.
But companies expect conditions to worsen in the three months ahead as they face stubbornly high costs, slowing overseas growth and uncertainty over Trump's policies.
"The outlook is highly uncertain due partly to Trump's tariff policies, which could weigh on automakers' profits," said Sakai at Mizuho Research & Technologies.
"Non-manufacturers are also cautious about the outlook as they feel the pinch from labour shortages. The outlook for consumption is also weak due to prolonged price rises," he added.
The BOJ ended negative interest rates in March and raised its short-term policy rate to 0.25% in July on the view Japan was making steady progress towards sustainably achieving its 2% inflation target.
BOJ Governor Kazuo Ueda has said the central bank will continue to raise rates if companies keep hiking prices and wages due to optimism over the outlook, and help keep inflation durably around its 2% target.
Sources have told Reuters the BOJ is leaning toward keeping interest rates steady next week as policymakers prefer to spend more time scrutinising overseas risks, though there is no consensus on the final decision.
The tankan's sentiment diffusion indexes are derived by subtracting the number of respondents who say conditions are poor from those who say they are good. A positive reading means optimists outnumber pessimists.