By Leika Kihara
TOKYO (Reuters) -Japan's&nbsp;bitter memories of its decades-long&nbsp;battle&nbsp;with&nbsp;deflation&nbsp;hang heavily over the central bank's deliberations to take its first modest step away from ultra-loose monetary&nbsp;policy, even as inflation and wages creep up.
The appointment of Kazuo Ueda as Bank of Japan (BOJ) governor this year and mounting price pressures have fired up market chatter that the new chief might hasten an exit from the bold stimulus of his predecessor Haruhiko Kuroda.
But uncertainty over the wage outlook and emerging global economic weakness heighten the chance the&nbsp;BOJ&nbsp;will hold off tweaking its controversial yield curve control (YCC)&nbsp;policy&nbsp;at least until autumn, say three sources familiar with its thinking.
"In a country that has seen interest rates stay ultra-low for two decades, the shock of the&nbsp;BOJ's first move could be enormous," said one of the sources. "That's enough to make the&nbsp;BOJ&nbsp;cautious."
Japan has not seen interest rates rise since 2007, when the&nbsp;BOJ&nbsp;hiked short-term rates to 0.5% from 0.25% in a move later criticised for delaying an end to price stagnation.
Having taken part in&nbsp;Japan's&nbsp;battle&nbsp;with&nbsp;deflation&nbsp;as&nbsp;BOJ&nbsp;board member from 1998 to 2005, Ueda knows all too well the danger of a premature exit from ultra-loose&nbsp;policy.
Wary&nbsp;of a wobbly recovery, he opposed the&nbsp;BOJ's decision in 2000 to raise short-term rates to 0.25% from zero.
The bank drew significant political heat for that tightening and was forced to reverse course just eight months later and adopt quantitative easing.
Given the&nbsp;trauma&nbsp;of such ill-timed&nbsp;policy&nbsp;shifts, caution will be Ueda's priority, the sources say, suggesting an end to YCC, which caps the 10-year bond yield around zero, could be some time away. That would mean more significant&nbsp;policy&nbsp;changes are even further down the track.
"Tweaking the yield cap alone may not do much harm to the economy, as long as short-term rates are kept low," one of the sources said. "But the&nbsp;BOJ's long, historical struggle with&nbsp;deflation&nbsp;can't be taken lightly."
SHIFTING PRIORITIES
One key difference between the&nbsp;BOJ's and the market's thinking lies in&nbsp;Japan's&nbsp;inflation outlook.
On the surface, conditions for phasing out a portion of the&nbsp;BOJ's massive stimulus appear to be falling in shape.
Core consumer inflation hit 3.4% in April, holding above the&nbsp;BOJ's 2% target for over an year, as companies continued to hike prices for a broad range of goods and services.
Companies offered pay hikes not seen in three decades in this year's wage talks with unions, heightening hope of a sustained rise in pay after decades of stagnant wage growth.
With robust domestic demand offsetting some of the external headwinds, the&nbsp;BOJ&nbsp;is widely expected to raise this year's inflation forecasts at its next quarterly review in July.
But inflation is now less of a trigger for an exit than it was in the past, as&nbsp;policymakers focus on risks that could again upend the path toward a sustained recovery.
"If you know the U.S. economy could slow sharply due to aggressive rate hikes in the past, it's natural for the&nbsp;BOJ&nbsp;to be cautious about phasing out stimulus," a third source said.
Weakness in China, a major market for Japanese manufacturers, also casts doubt over whether companies can reap enough profits to sustain wage hikes next year.
To be sure, Ueda has left scope to tweak YCC in case inflation continues to overshoot the&nbsp;BOJ's forecasts. At his debut&nbsp;policy&nbsp;meeting in April, he removed guidance pledging to keep rates at "current or lower levels."
In a group interview last month, Ueda said the&nbsp;BOJ&nbsp;could tweak YCC "if the balance between the benefit and cost of our&nbsp;policy&nbsp;shifts."
With Kuroda's massive stimulus having failed to re-anchor inflation expectations around the&nbsp;BOJ's target, however, Ueda has good reason to be cautious.
Ueda last month said eradicating&nbsp;Japan's&nbsp;entrenched&nbsp;deflationary mindset remained a difficult challenge and warned moving too quickly on rates was more dangerous than not moving fast enough.
"The cost of waiting for underlying inflation to rise until it can be judged that 2% inflation has fully taken hold is not as large as the cost of making hasty&nbsp;policy&nbsp;changes," he said.
(Reporting by Leika Kihara; Editing by Sam Holmes)

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Trauma of Japan's deflation battle keeps BOJ wary of policy shift