By Leika Kihara and Takahiko Wada

TOKYO The Bank of Japan (BOJ) may raise short-term interest rates early next year if sustained wage growth becomes a real prospect, Tsutomu Watanabe, an academic who participated in a key government panel on economic policy, told Reuters.

Inflation will remain elevated as companies become more convinced that they can hike prices without scaring away consumers, said Watanabe, a former BOJ official and an expert on Japan's price trends.

"Talking to firms and looking at various data, it's hard to see inflation slow ahead," Watanabe said in an interview on Tuesday. "Japan is already seeing budding signs of sustained, domestic demand-driven inflation."

His projection contrasts with the BOJ's view that inflation, which is now well above its 2% target, will slow back below that level later this year as the boost from past rises in import costs dissipate.

Despite prospects of rising inflation, the BOJ must maintain ultra-loose policy for now given uncertainty on whether firms would continue to raise pay next year, he said.

"It's important that a virtuous cycle of durable inflation and wage growth becomes embedded in society. Once that happens, the BOJ can normalise monetary policy," Watanabe said.

Before raising short-term rates, the BOJ must dismantle yield curve control (YCC) by removing a 0% target set for the 10-year bond yield, he said.

"Controlling the shape of the yield curve with two rate targets has proved difficult when global market forces put upward pressure on bond yields," Watanabe said, adding that YCC must be abandoned as soon as possible.

Once the 10-year yield target is removed, the BOJ can raise short-term rates to positive territory, he added.

"If the BOJ sees prospects of sustained wage growth, it may raise short-term rates early next year," he said.

Under YCC, the BOJ sets a short-term rate target at -0.1% and guides the 10-year bond yield around 0%.

Japanese firms offered wage hikes not seen in the past three decades at this year's negotiation with unions, as they faced pressure to compensate employees for the rising cost of living.

Markets are rife with speculation that new BOJ governor Kazuo Ueda will gradually dismantle his predecessor's massive stimulus including YCC, which has drawn criticism for distorting bond market pricing and triggering excessive yen falls that pushed up import costs.

Ueda, however, has stressed the need to wait until wage growth becomes more sustained, before phasing out ultra-loose policy.

Watanabe who, as an academic knows Ueda well, welcomed the governor's decision to add wage growth to the BOJ's guidance that pledges to keep ultra-loose monetary policy.

He said the BOJ could offer more clarity on what kinds of wage data it will focus on in deciding when to end ultra-loose policy, to increase predictability of its policy direction.

A professor at the University of Tokyo, Watanabe was among academics who spoke at a key government panel session on macro-economic policy held earlier this month. He is also a frequent speaker at BOJ-hosted seminars.

(Reporting by Leika Kihara; Editing by Sam Holmes)