By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) - The Bank of Japan signalled confidence the economy will emerge from the coronavirus pandemic's devastating blow and ruled out the risk of deflation, suggesting a pause in monetary easing after it delivered stimulus twice so far this year.
But Governor Haruhiko Kuroda warned the outlook was highly uncertain and stressed the BOJ's readiness to loosen policy settings again if risks, such as a resurgence in infections, derails the fragile recovery.
"We expect the economy to recover gradually and steadily," Kuroda told reporters on Wednesday.
"If further steps are needed, we of course won't hesitate to take additional easing steps. Options include an expansion in our lending facilities, as well as cuts in our short- and long-term interest rate targets."
Kuroda's remarks came after the BOJ maintained its short-term rate target at -0.1% and a pledge to cap 10-year government bond yields around zero, as widely expected.
It also made no changes to its asset-buying and lending programmes for easing corporate funding strains.
"There isn't any way for monetary policy to stimulate economic conditions right now. I don't think the BOJ can do anything at this stage apart from providing cash flow support so that (conditions) don't worsen further," said Atsushi Takeda, chief economist at Itochu Economic Research Institute.
In fresh quarterly forecasts, the BOJ expects the economy to shrink a median 4.7% in the current year ending in March, from a range of -5.0% to -3.0% projected in April, before expanding 3.3% the following year.
Consumer prices were forecast to fall 0.5% this year and stay well below its 2% target through early 2023.
BANK, PRICE WOES LOOM
The BOJ loosened policy in March and April focusing on steps to ease tight liquidity, such as boosting asset purchases and creating a lending scheme as the pandemic hurt jobs, spending and depressed business activity.
Businesses have re-opened after lockdown steps were lifted in late May. But Tokyo raised its alert for coronavirus infections on Wednesday after a spike in cases to record numbers in the capital, casting doubt on the economy's recovery prospects.
The BOJ, which has for years deployed aggressive monetary easing to reflate the economy, is seen having limited ammunition left to deal with the economic impact of the pandemic.
While Kuroda did not rule out rate cuts as among options if the BOJ were to ease, analysts warn that doing so could hurt commercial banks' profits and their ability to lend.
In a sign of its concern over financial stability, the BOJ warned in its quarterly report that prolonged pressure on financial institutions' profits could discourage them from lending and prod them to take on excessive risk in search for yields.
"If the pandemic is prolonged and exerts bigger-than-expected downward pressure on the economy, some companies may face not just liquidity problems but solvency problems. That may push up credit costs for banks," Kuroda said.
There was also uncertainty on how the pandemic could affect corporate price-setting behaviour, as firms are caught between cutting prices due to weak demand and passing on rising costs from supply constraints to consumers, the report said.
Kuroda conceded that inflation expectations were weak, but signalled confidence that conditions will improve ahead.
"It's true short-term inflation expectation gauges are falling, but those for long-term inflation expectations aren't falling much," he said.
"I don't think there is a risk Japan will slide into deflation, defined as sustained periods of price declines."
(Reporting by Leika Kihara and Tetsushi Kajimoto; Additional reporting by Kaori Kaneko and Daniel Leussink; Editing by Jacqueline Wong)