By Leika Kihara and Stanley White
TOKYO (Reuters) - The Bank of Japan kept monetary policy steady on Wednesday and slightly trimmed its inflation forecasts as global trade frictions clouded the economic outlook, reinforcing views the central bank is in no rush to trim its massive stimulus.
But the BOJ issued a slightly stronger warning on financial vulnerabilities than it did three months ago, reflecting growing concerns that years of ultra-low rates were hurting bank profits and could discourage them from increasing lending.
"Prolonged downward pressure on financial institutions' profits from low interest rates... could destabilize the financial system," the BOJ said in a quarterly report assessing the long-term economic outlook and risks.
"Although these risks are judged as not significant at this point, it's necessary to pay close attention to future developments," it said. In the previous report in July, the BOJ only said such risks were not materializing.
As widely expected, the BOJ maintained a pledge to guide short-term interest rates at minus 0.1 percent and long-term rates around zero percent by a 7-2 vote.
Caught between heightening external risks to growth and the mounting demerits of prolonged easing, the BOJ is set to keep policy steady for some time, analysts say.
"If it weren't for the trade friction, the BOJ would be looking for ways to normalize policy. Normalization is off the cards for now," said Hiroshi Miyazaki, senior economist at Mitsubishi UFJ Morgan Stanley (NYSE:MS) Securities.
"There is no need to ease policy, but at the same time the BOJ can't normalize policy due to worries about trade and the chance the yen will rise."
In the quarterly report, the central bank cut its core consumer inflation forecast for the current fiscal year ending March 2019 to 0.9 percent from 1.1 percent three months ago.
It also slightly trimmed its price forecasts for the following two years and now projects inflation to hit 1.5 percent in the year ending in March 2021 - short of its 2 percent target.
"The downgrade to the BOJ's inflation forecasts underlines that policy tightening remains a long way off," said Marcel Thieliant, senior Japan economist at Capital Economics.
"If anything, the board has become more pessimistic about the prospects of hitting its 2 percent inflation target."
Inflation has remained subdued despite Japan's steady economic expansion, forcing the BOJ to maintain stimulus despite the impact on bank profits from years of near-zero rates.
The central bank took steps in July to make its policy framework more sustainable, such as allowing bond yields to move more flexibly around its target.
But the measures have done little to revive bond market trading or give relief to banks. In a semi-annual review of Japan's banking system, the BOJ warned that risk-taking in Japan's financial sector hit a near three-decade high as they struggle to earn profits.
Adding to headwinds for meeting the BOJ's price target, a recent batch of weak data suggests Japan's economy may have peaked. Many analysts warn that intensifying trade frictions and slowing Chinese demand could weigh on business sentiment and discourage firms from boosting spending.
Japanese factory output fell more than expected in September as a series of typhoons and earthquakes disrupted production, data released earlier on Wednesday showed, reinforcing expectations the economy may have contracted slightly in the third quarter.