By Leika Kihara

TOKYO (Reuters) -The Bank of Japan said broadening wage hikes were underpinning consumption and prodding more firms in regional areas to pass on rising labour costs, signalling the economy was making progress towards meeting the prerequisite for more interest rate hikes.

But the central bank warned that some small and medium-sized firms were struggling to earn enough profits to hike wages, a development that “required vigilance.”

“This year’s wage increases were helping push up consumption with some firms pointing to the effect of solid spending by the younger generation, which enjoyed fairly big pay hikes,” the BOJ said on Monday in a quarterly report on regional economies.

The report will be among factors the BOJ will scrutinise at its next policy-setting meeting on Oct. 30-31, when the board will also conduct a quarterly review of its growth outlook.

A majority of economists polled by Reuters on Sept. 4-12 had expected the BOJ to raise rates again by year-end.

In the report, the BOJ revised up its assessment for two of nine regional areas in Japan and left intact the view for the remaining regions to say they were recovering moderately.

The BOJ ended negative interest rates in March and raised its short-term rate target to 0.25% in July on the view Japan was on track to durably meet the bank’s 2% inflation target.

BOJ Governor Kazuo Ueda has signalled readiness to raise rates further if broadening wage hikes underpin consumption, and allow companies to keep hiking prices not just for goods but services.

“A growing number of firms likely see the need to keep hiking pay” in next year’s annual wage negotiations due to labour shortages, though some firms complain of weak profits that make it hard to increase salaries, the report said.

“While some companies said they were struggling to pass on expected rises in labour costs, a growing number of firms in the service sector were doing so or were considering doing so,” the report said.

Japan’s economy expanded by an annualised 2.9% rate on solid consumption and core inflation remains above the central bank’s 2% target, keeping alive expectations for further rate hikes.

But weak demand in China, slowing U.S. growth and the yen’s rebound cloud the outlook for the export-reliant economy.

Governor Ueda has said the BOJ can afford to spend time scrutinising the fallout from U.S. economic uncertainty in judging whether to hike rages, signalling the bank was in no rush to push up borrowing costs.

In the report, the BOJ revised up its assessment on output in the central Japan region – home to auto giant Toyota Motor Corp – as disruptions in auto production in some factories run its course.

Kazushige Kamiyama, the BOJ’s branch manager overseeing the western Japan region, also said excessive yen falls, rather than the currency’s rebound, is still seen by many firms as a bigger risk.

“Quite a large number of firms seem to share the view it was problematic for the yen to decline too much,” Kamiyama told a news conference. However, he said there was growing attention among firms on Chinese and U.S. economic uncertainties.

“Many firms are setting their business strategies on the assumption the slowdown in exports to China will continue for some time,” Kamiyama said.

(Reporting by Leika KiharaEditing by Chang-Ran Kim, Kim Coghill & Shri Navaratnam)

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