FILE PHOTO: The Japanese national flag waves at the Bank of Japan building in Tokyo, Japan March 18, 2024. REUTERS/Kim Kyung-Hoon/File Photo

By Leika Kihara and Takahiko Wada

TOKYO (Reuters) -The Bank of Japan can raise interest rates if prospects of durably meeting its 2% inflation target improve, but would struggle to justify doing so this year given weak signs in the economy, former deputy governor Masazumi Wakatabe told Reuters.

Wakatabe, who is known as a fiscal and monetary dove, endorsed the central bank's cautious policy normalisation and said more rate hikes could come if the economy improves.

He noted the economy was "at a historical turning point" with companies raising prices on a regular basis in a departure from their past caution over doing so.

"If the economy is improving steadily, and the likelihood of sustainably and durably achieving 2% inflation is heightening, an interest rate hike would obviously be on the table," he said in an interview on Wednesday.

But Wakatabe warned of recent weak signs in the economy that suggest underlying inflation, which has been flat around 1.6%, may not accelerate much. Private economists also project Japan's economy to contract in the third quarter, Wakatabe added.

"Recent data shows Japan's labour market stagnating. If Japan's third-quarter GDP data prove weak, it would be hard to justify raising rates in December," he said.

The government will release third-quarter gross domestic product (GDP) data on November 17. After a meeting slated for October 29-30, the BOJ board holds its final policy-setting meeting for this year on December 18-19.

An advocate of expansionary fiscal and monetary policy, Wakatabe is among academics with ties to Sanae Takaichi, who is on course to become next premier after her victory in a weekend ruling party leadership race.

Upon winning the race, Takaichi made clear the government will take the lead in setting fiscal and monetary policy - and that her priority would be to reflate domestic demand.

Wakatabe said the BOJ must coordinate closely with the government, but does not necessarily need to keep interest rates low solely for the purpose of financing government spending.

"If inflation expectations rise and push up underlying inflation, the BOJ can raise interest rates. It needs to do so because otherwise, the economy will overheat," Wakatabe said.

"On the other hand, the BOJ needs to keep the economy on a firm footing. It's about finding the right balance, looking at data. I think the BOJ understands this point."

The yen slumped to an eight-month low against the dollar this week as markets saw Takaichi's win as reducing the chance of a near-term rate hike.

"The BOJ hasn't committed to a set timing for raising rates and hasn't dropped any signals," Wakatabe said. "It's really dependent on data."

Wakatabe served as deputy governor for five years through 2023, during which the BOJ maintained a massive stimulus deployed by former governor Haruhiko Kuroda in 2013. Under incumbent governor Kazuo Ueda, the BOJ exited Kuroda's stimulus last year and raised interest rates to 0.5% in January.

Currently an economics professor at Japan's Waseda University, Wakatabe wrote a chapter on fiscal and monetary policy in a book Takaichi published last year.

(Reporting by Leika Kihara and Takahiko Wada; Editing by Sam Holmes)