By Leika Kihara and Tetsushi Kajimoto

TOKYO (Reuters) -Japanese manufacturers’ mood soured in the final quarter of 2022 to its lowest in nearly two years, a central bank survey showed, as cost pressures and the prospect of slowing global demand clouded the outlook for the world’s third-largest economy.

But service-sector sentiment improved for three straight quarters in the October-December period, the Bank of Japan’s closely watched “tankan” survey showed on Wednesday, as the impact on consumption from the coronavirus pandemic faded.

The outcome illustrated the divergence between robust domestic demand, which is making a delayed recovery from the pandemic’s scars, and the darkening outlook for exports on fears of global recession, analysts say.

It also highlighted the challenge policymakers face in prodding companies to raise wages and compensate households for the rising cost of living – a factor the BOJ sees as crucial for inflation to sustainably hit its 2% goal.

“Japan’s economy isn’t in bad shape, with firms maintaining their bullish spending plans. Companies will also raise wages next year,” said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute.

“But the key is the outlook for overseas economy, as domestic demand isn’t strong enough to compensate for the hit from any big slump in global growth,” he said.

The headline index for big manufacturers’ sentiment fell to plus 7 in December from plus 8 in September, the tankan showed, worsening for the fourth straight quarter and marking the lowest level since March 2021. It compared with a median market forecast for a reading of plus 6.

The big non-manufacturers’ confidence index rose to plus 19 from plus 14, beating market forecasts of plus 17 and hitting its highest level since December 2019, the survey showed.

Both big manufacturers and non-manufacturers expect business conditions to worsen ahead, the survey showed, reflecting rising raw material costs and fears of weakening global demand.

Although some firms complained about the hit from rising raw material costs, others saw relief from easing supply constraints and progress made in price increases, the survey showed.

Sentiment among big hotels and restaurants rebounded to the highest level since 2019, as the removal of COVID-19 curbs and the opening of borders lifted consumption, it showed.

Big firms expect to increase capital expenditure by 19.2% in the current fiscal year, which ends in March 2023, after a 2.3% decline in the previous year, it showed.

“While the slowdown in global economy is a source of concern, I think the economy’s positive trend will continue next year,” said Yoshimasa Maruyama, chief economist at SMBC Nikko Securities.

The tankan survey also showed corporate one-year and three-year inflation expectations hitting a fresh record.

Core consumer prices rose 3.6% in November from a year earlier, the fastest pace in 40 years and exceeding the BOJ’s 2% target for a seventh straight month, as the yen’s slump inflated the cost of importing already expensive fuel and food.

The rising cost pressure took a toll on businesses and households, which was behind the economy’s unexpected contraction of an annualised 0.8% in the third quarter.

Analysts expect growth to rebound in the current quarter due to easing supply constraints and lifting of COVID-19 border controls, though weakening global demand may cloud the outlook.

(Reporting by Leika Kihara; Editing by Sam Holmes and Gerry Doyle)

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