By Leika Kihara
TOKYO (Reuters) - Japan's economic output exceeded its full capacity in October-December by the most in more than 26 years, offering the central bank some hope a sustained recovery will help inflation accelerate toward its elusive 2 percent target.
But the Bank of Japan will likely maintain a dovish tone as heightening overseas risks threaten to derail the country's export-reliant recovery, say sources familiar with its thinking.
The data, along with a BOJ survey on Monday showing a sharp deterioration in business sentiment, will be among factors the central bank will scrutinise in deciding whether to maintain its view that growth will rebound in the latter half of this year.
"The headwinds from China's slowdown haven't hurt capital expenditure yet," one of the sources said on condition of anonymity. "But overseas developments, particularly on how China performs, will be key to whether the BOJ's scenario holds."
Japan's output gap, which measures the difference between an economy's actual and potential output, stood at plus 2.2 percent in October-December, a BOJ estimate showed on Wednesday, staying positive for nine straight quarters.
It was wider than a 1.26 percent gap in the previous quarter and the biggest positive gap since 1992, when Japan was still experiencing an asset-inflation "bubble" period.
A positive output gap occurs when actual output exceeds the economy's full capacity, as factories and workers operate above their most efficient level to meet strong demand.
In theory, a growing positive output gap should lead to a build-up of inflationary pressure, though the BOJ has conceded that structural factors could keep price growth subdued for longer than expected.
Business confidence hit a two-year low in the March quarter, the BOJ's "tankan" survey showed on Monday, underscoring concerns that Sino-U.S. trade tensions and softening global demand were taking a toll on the economy. [nL3N21J03E]
But many in the central bank feel Japan's economy has not lost its momentum to accelerate inflation to its 2 percent target, citing tankan figures pointing to resilience in capital expenditure plans, the sources say.
In March, the BOJ stuck to its view Japan's economy was expanding moderately, clinging to hope that growth will pick up in the latter half of this year as global demand emerges from the doldrums.
Whether the second-half rebound scenario holds will be among key topics of debate at the April rate review, the sources said.
While some policymakers have signalled the need to ramp up stimulus to pre-empt risks, most in the nine-member board prefer to hold off on acting immediately given the rising cost of prolonged easing and a dearth of policy ammunition, they say.
Aside from reviewing policy, the BOJ will issue fresh quarterly economic growth and inflation projections at its rate review on April 24-25.
The BOJ faces a dilemma. Years of heavy money printing have dried up market liquidity and hurt commercial banks' profits, highlighting the rising risks of prolonged easing.
And yet, subdued inflation has left the BOJ well behind its U.S. and European counterparts in dialling back crisis-mode policies, and with a dearth of ammunition to battle any abrupt yen spike that could derail an export-driven economic recovery.
