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 Makiko Yamazaki

TOKYO (Reuters) -The Bank of Japan kept interest rates steady on Thursday but repeated its pledge to continue increasing borrowing costs if the economy moves in line with its projections, shifting investor focus to the prospect of a hike as soon as December.

While the central bank roughly maintained its long-term forecasts, it elaborated on overseas risks that may hurt Japan's recovery in a sign of its focus on growth concerns.

The yen fell in the wake of the central bank's widely expected decision to maintain short-term interest rates at 0.5%. Board members Naoki Tamura and Hajime Takata dissented to the decision, repeating their proposals made in September to raise rates to 0.75%.

Investors will now look for any clues from Governor Kazuo Ueda's post-meeting news briefing on the timing and pace of future rate hikes.

"The BOJ is tip-toeing towards a hike. With inflation remaining elevated, economic performance on a decent track, and fiscal tailwinds gathering speed, it remains a question of when, not if, the BOJ will hike," said Fred Neumann, chief Asia economist at HSBC in Hong Kong.

"While markets have pushed back expectations for monetary tightening by Japan's central bank, officials may hike policy rates sooner rather than later."

In a quarterly outlook report released on Thursday, the board slightly revised up its economic growth forecast for the current fiscal year ending in March 2026.

It upgraded its inflation forecast for fiscal 2026 but left unchanged its view that risks to the price outlook were roughly balanced.

The BOJ also said it expects underlying inflation to hit 2% in the latter half of the three-year projection period through fiscal 2027, retaining language in the previous report in July.

"If our economic and price projections materialise, we will continue to raise our policy rate and adjust the degree of monetary support in accordance with improvements in the economy and prices," the BOJ said in the report.

While projecting Japan's economy to stay on course for a moderate recovery, the report elaborated on overseas risks such as uncertainties over the impact of President Donald Trump's tariffs on the U.S. economy, and how artificial intelligence (AI) demand could affect global growth.

"Attention is warranted on how tariffs could affect U.S. job and income conditions via deteriorating corporate profits, as well as the impact on U.S. consumption," the report said, a sign of the BOJ's focus on one of Japan's biggest export markets.

The board has been split between hawks who see conditions ripe to raise rates and doves like Ueda who prefer awaiting more data on the extent of damage from slowing U.S. growth and Trump's tariffs.

Uncertainty over the impact of tariffs also overshadowed discussions at the U.S. Federal Reserve, which delivered another interest rate cut on Wednesday but by a split vote. Fed Chair Jerome Powell pointed to "strongly differing views" among his colleagues about the appropriate future policy path.

NEW POLITICAL CHALLENGES FOR BOJ

Aside from looming overseas risks, politics have complicated the BOJ's decision. Markets reduced bets on an October rate hike after last week's inauguration of new Prime Minister Sanae Takaichi, who is known as an advocate of loose monetary policy.

With inflation exceeding the BOJ's target for well over three years, however, a majority of economists polled by Reuters expect the BOJ to raise rates either in October or December. Nearly all project a hike to 0.75% happening by end-March.

Hawks in the BOJ board may also find an ally in U.S. Treasury Secretary Scott Bessent, who called for speedier rate hikes to avoid weakening the currency too much.

"With policy consistency confirmed vis‑à‑vis the Takaichi administration, the FX market is likely to see continued downward pressure on the yen," said Hirofumi Suzuki, chief FX strategist at SMBC in Tokyo.

"Assuming the BOJ continues to favour a gradual pace of rate increases, I expect an additional hike to be decided at the December policy meeting."

The BOJ last year exited a decade-long, massive stimulus programme and raised rates to 0.5% in January on the view Japan was close to durably hitting its 2% inflation target.

While Ueda has signaled the bank's readiness to keep raising rates, he has preferred treading cautiously on concerns the hit from U.S. tariffs could derail a cycle of rising wages and prices - a prerequisite for policy normalisation.

(Reporting by Leika Kihara and Makiko Yamazaki; additional reporting by Satoshi Sugiyama and Kantaro Komiya; Editing by Sam Holmes)