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The Bank of Japan upgraded its view on the economy and financial conditions on Thursday, paving the way for a broader debate next month on whether to start phasing out its measures to support corporate funding.

The BOJ also said exports and output were increasing thanks to a recovery in overseas markets, especially in emerging economies.

The central bank’s policy board voted unanimously to keep interest rates on hold at 0.1% as widely expected.

"Financial conditions remain severe but are increasingly showing signs of improvement," the BOJ said in a statement.

Record deflation, rising job losses and weak capital spending mean the central bank is likely to keep its bias tilted towards the downside, which may complicate the debate on the timing for exiting its special measures.

"Japan’s gradual economic improvement does seem to be on track. The BOJ is understandably cautious about the remaining uncertainties to the economic outlook, but interest rates are as low as they can go and will likely stay there for some time," said David Cohen, director of Asian economic forecasting at Action Economics in Singapore.

"The BOJ may look toward ending some of its steps for corporate finance, but when you compare Japan with other economies, no one is really expecting inflation in Japan."

The central bank is widely expected to keep rates at 0.1% until at least March 2011.

Central banks around the world have begun debating how and when to phase out their emergency steps to contain the damage wrought by the worst global financial crisis in decades, but most are not expected to do so until well into next year.

The BOJ maintained its view on prices, saying that annual core consumer price falls would narrow in the latter half of the year to March 2010.

BOJ Governor Masaaki Shirakawa is likely to repeat the view at his post-meeting news conference that price falls will not accelerate enough to warrant further monetary easing.

The BOJ has extended its support measures for corporate funding, including buying commercial paper (CP) and corporate bonds from banks, to the end of December.

But the average issue rate for one-month CP fell to 0.21% in August from a peak of 1.34% last December, and there is a growing feeling at the BOJ that it could let some of its special steps expire in December without disrupting markets.

Japanese exports and output have bounced back from a steep fall triggered by the global crisis, helping the economy return to growth in the second quarter.

BOJ officials will scrutinize the bank’s closely watched tankan business confidence survey due on Oct. 1 for clues on whether corporate sentiment and spending appetite are improving not just for big firms but also for smaller ones.

The Reuters Tankan, a leading indicator for the BOJ’s survey, showed on Thursday that manufacturers were at their least pessimistic in a year in September and expect conditions to improve further in the next three months.

But weakness remained in non-manufacturers’ sentiment, which improved from last month but was worse than three months ago.

A separate survey by the Ministry of Finance and the Cabinet Office also showed big manufacturers turned optimistic about business conditions in the three months to September compared with the previous quarter.  

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