By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) -Incoming Bank of Japan (BOJ) Governor Kazuo Ueda said on Friday the central bank must maintain ultra-low interest rates to support the fragile economy, warning of the dangers of responding to cost-driven inflation with monetary tightening.
While signalling the chance of tweaking the BOJ's bond yield curve control (YCC) in the future, Ueda said the bank needed to work out the right timing and means to do so, a sign the new chief will be in no rush to overhaul the controversial policy.
Speaking to lawmakers, Ueda said the recent rise in inflation is driven largely by rising raw material import costs, rather than strong demand, adding the outlook for Japan's economy was highly uncertain.
Global bond yields fell and Japanese stocks rallied as Ueda's emphasis on patience and continuity in policy tempered some market expectation that he might seek to make a hasty exit from the extreme monetary stimulus of his dovish predecessor, Haruhiko Kuroda.
"It's standard practice to act preemptively to demand-driven inflation, but not respond immediately to supply-driven inflation," Ueda told a lower house confirmation hearing.
"Japan's trend inflation is likely to rise gradually. But it will take some time for inflation to sustainably and stably achieve the BOJ's 2% target," he said.
"It's true there are various side-effects emerging from the stimulus. But the BOJ's current policy is a necessary, appropriate means to achieve 2% inflation."
The yen was volatile, swinging between gains and losses against the dollar as investors parsed through Ueda's comments. It was last off 0.03% at 134.76 per dollar.
Earlier this month, the government named the 71-year-old academic as its pick to become next central bank governor in a surprise choice that markets initially saw as heightening the chance of an end to the unpopular YCC policy.
With inflation exceeding the BOJ's target, Ueda faces the delicate task of phasing out YCC, which has drawn public criticism for distorting market functions and crushing banks' margins.
"There are various possibilities on what YCC could look like in the future," he said, adding that there were side-effects emerging from the policy such as deteriorating market function.
But he said for now, the BOJ needed to monitor whether the measures it took in December, such as widening the band around its yield target, will help ease the side-effects.
Ueda's caution against shifting policy too soon was echoed by Shinichi Uchida, a career central banker and the government's deputy BOJ governor nominee, who said it was inappropriate to tweak ultra-loose policy just to deal with its side-effects.
"The BOJ's current interest rate target levels, including the negative short-term rate, is appropriate. If Japan can foresee inflation reaching 2%, the target levels could be reviewed. But that won't come immediately," Uchida told lawmakers in the same confirmation hearing.
EXIT POSSIBILITIES
Targeting shorter-maturity bond yields, rather than the current 10-year yield, may be among options, though there are various other ideas if the BOJ were to tweak YCC in the future, Ueda said.
"If trend inflation heightens significantly and sustained achievement of the BOJ's 2% target comes into sight, the central bank must consider normalising monetary policy," Ueda said.
In phasing out stimulus, the BOJ would do so by raising interest rates on financial institutions' reserves parked with the central bank rather than selling bonds, Ueda said.
Upon approval by parliament, Ueda succeeds incumbent Kuroda, whose second, five-year term ends on April 8.
"Overall Ueda is working hard to present himself as delivering continuity - at least to start with," said Sean Callow, senior currency strategist at Westpac. "Now is not the time to put his own stamp on policy; that's not why the government selected him."
The upper house of parliament will hold the confirmation hearing for Ueda on Monday, and that for the two deputies on Tuesday.
The nominations need the approval of both chambers of the Diet, which are effectively done deals as the ruling coalition holds solid majorities in both.
Under YCC, the BOJ guides short-term interest rates at -0.1% and the 10-year bond yield around 0% as part of efforts to sustainably achieve its 2% inflation target.
Facing pressure from rising global interest rates, the BOJ was forced to raise in December the implicit cap for its 10-year yield target to 0.5% from 0.25% - a move that fuelled market expectations of an imminent tweak to YCC.