By Natsuko Waki and Naomi Tajitsu
LONDON, May 13 (Reuters) - Japan's economy is showing signs of recovery and is expected to start to stabilise towards the end of this year, but the Bank of Japan is closely monitoring developments, its governor said on Wednesday.
Speaking at an event in London, BOJ Governor Masaaki Shirakawa warned that what he called an "adverse feedback loop" between the financial system and real economy persisted globally and he cautioned against complacency.
The BOJ has slashed its economic forecasts but projected a recovery by early next year in a half-yearly outlook report.
"The Japanese economy literally fell off a cliff... More recently, we have seen some positive signs as industrial production has increased for the first time in six months," Shirakawa said in a speech.
"Although we expect the pace of deterioration in economic conditions to moderate gradually and the economy to start to level out towards the end of the year, we are closely watching developments."
In Japan, bankruptcies and joblessness are on the rise despite the government's $156 billion stimulus package, suggesting that any economic recovery in Japan, in its worst recession since World War Two, could be slow and fragile as pain from the global financial crisis spreads.
Echoing other central bankers who have spoken out against excessive optimism in recent days, Shirakawa said policymakers should be watchful of downside risks.
"The adverse feedback loop between the financial system and real economy stubbornly remains, though there are some slight signs of improvement," he said.
"We all have to be humble in avoiding complacency... We must be mindful of the fallacy... that benign economic conditions will continue for an extended period into the future (and) that policymakers can deal effectively with the bursting of the bubble through aggressive ex-post monetary and fiscal policy."
PRICE STABILITY
Japan's benchmark interest rate is already at a rock-bottom level of 0.1 percent.
At its April meeting, the BOJ decided to lend against a wider range of municipal debt in a move to support regional banks reeling from their borrowers' worsening revenues.
The BOJ does not have numerical inflation targeting. Instead, it publishes its "understanding of medium- to long-term price stability".
Shirakawa said a specific number in the inflation targeting framework could foster the presumption that a central bank is expected to focus narrowly on price inflation alone in the short term.
"It may have the unintented effect of assisting the creation of bubbles when low inflation co-exists with an excessive boom in economic and financial activity," he said.
"If this is the case, it may hinder the central bank's longer-term goal of maintaining stable prices and a stable financial system."
Shirakawa added central banks should focus both on maintaining the smooth functioning of financial markets and the system as well as price stability.
(Reporting by Natsuko Waki and Naomi Tajitsu; Editing by Jason Neely)