BOJ chief vows to debate 'pros and cons' of rate hike, signals June action

* Japan more exposed to spillover effects of inflation

* BOJ will keep raising rates at 'appropriate pace', Ueda says

* Ueda signals rate-hike chance even if Iran uncertainty remains

* Delaying rate hike may inflict huge burden on economy

* Speech heightens chance of June rate hike, analysts say

By Leika Kihara

TOKYO, June 3 (Reuters) - Bank of Japan Governor Kazuo Ueda said the central bank must discuss the pros and cons of raising interest rates if inflationary risks outweigh downside risks to the economy, in comments that signal a high chance of a rate hike this month.

Given the huge energy shock caused by the Middle East war, the central bank must pay more attention to the risk of an inflation overshoot than the chance of the conflict hurting the economy, Ueda said in a speech delivered to a seminar.

"Japan is currently in a situation in which the secondary spillover effects of inflation stemming from higher crude oil prices are more likely to lead to an overshoot of underlying inflation," Ueda said on Wednesday. "We believe it's necessary to make decisions on future policy based on this premise."

The dollar fell 0.3% against the yen to 159.40 after Ueda's remarks, which heightened the chance for the BOJ to raise its policy rate to 1% from 0.75% at its next meeting on June 15 and 16, as many market players predicted.

"Ueda sounded hawkish and keen to raise rates," said Masato Koike, senior economist at Sompo Institute Plus. "The chance of a June rate hike has heightened significantly."

The seminar had drawn close attention from markets as a venue Ueda might use to signal the chance of a June rate hike, as the war-induced energy shock added to mounting inflationary pressure on the economy.

Ueda warned that price pressures from the energy shock might not prove temporary and could push up underlying inflation more than the BOJ projects.

The BOJ will continue to raise rates at an "appropriate pace" if economic and price developments move in line with its baseline scenario, he said.

"Meanwhile, even if the situation surrounding the Middle East remains unclear, we must discuss the pros and cons of raising the policy rate if we judge that upside risks to prices outweigh downside risks to economic activity."

Ueda repeated the comment when asked by the seminar's host about the likelihood of a rate hike in June.

DELAY MAY BE COSTLY

The BOJ exited a decade-long massive stimulus in 2024 and has raised its policy rate several times, including in December, on the view that Japan was on the cusp of durably achieving its inflation target of 2%.

Soaring energy costs from the Middle East conflict have complicated the BOJ's rate decisions as they push up prices, but also hurt an economy heavily reliant on fuel imports.

Even before Ueda's speech, various factors have pointed to strong prospects for a June rate hike. Wholesale inflation hit a three-year high in April, alarming policymakers with the speed at which firms passed on costs.

The BOJ's nine-member board has increasingly swung in favour of an early move. Three dissented to a decision in April to keep rates steady, while two others warned of mounting price pressures in recent speeches.

Markets had priced in roughly an 80% chance of a June rate hike. Nearly two-thirds of economists polled by Reuters last month also projected the BOJ to raise rates in June.

Ueda preached the benefits of raising Japan's still low real interest rates, arguing that timely rate hikes would keep bond yield rises in check by reassuring markets that inflation will be kept under control.

"If the central bank delays action necessary to combat inflation, it could be forced to hike rates substantially later and inflict a heavy burden on the economy, markets and the financial system," Ueda said.

"While the BOJ should be attentive to downside risks to economic activity, it should be more vigilant to the chance of inflationary risks materialising and exerting an adverse impact on the economy," he said. (Reporting by Leika Kihara; Editing by Clarence Fernandez and Toby Chopra)