The government said in its annual report on the economy Tuesday that the end of deflation is in sight and pressured the Bank of Japan to carry out future interest rate rises in a wise manner.

“Future increases in interest rates need to be implemented prudently, with their impact on each economic sector taken into account,” the Cabinet Office said in the Annual Report on the Japanese Economy and Public Finance 2006.

The central bank raised the key short-term interest rate to 0.25 percent from virtually zero last Friday, marking Japan’s first rate hike in six years and its return to normal monetary policy.

BOJ Gov. Toshihiko Fukui said the bank was not planning consecutive interest rate hikes.

Market players, however, are already speculating about the timing and depth of any subsequent rate hikes.

The report says the end of deflation is in sight and the government expects the economy to enter a sustained recovery, thanks to healthier corporate and household sectors and the steady recovery of the global economy.

“Judging from the price trend and its underlying factors, we are now close to breaking out of the deflationary trend,” it says. “However, we should remain cautious, as consumer prices are only rising at a moderate pace.”

Although data show that the consumer price index, excluding volatile perishables, has climbed for seven months in a row, the government has yet to declare deflation dead.

Policymakers and private-sector economists believe the core CPI, which rose 0.6 percent in May from a year ago, will keep rising but stay under 1 percent until yearend.

Despite optimism over economic and price developments, the report warns that soaring oil prices, the impact of rising global interest rates and jitters over the U.S. current account imbalances could be potentially destabilizing factors.

In addition, higher interest rates will pose a risk to corporate earnings because of yen appreciation, the report says. A 1 percentage point increase in interest rates can cut profits by about 3 trillion yen, the Cabinet Office said.

The impact of higher rates will be limited, however, as long as they rise moderately and in line with the economic recovery trend, the report says.

It says the growing number of young nonregular workers, including “freeters,” who earn their livings from temporary jobs, and NEETs, or young people “not in education, employment or training,” may fuel widening income gaps.

The report says it appears that income disparities are widening among young people, reflecting structural changes in the labor market, like the increasing numbers of freeters and NEETs, as companies reduce personnel costs through restructuring.

The report calls for establishing a system that gives young people vocational education and training after they enter the workforce and reinforces their education and training at school before they leave.

“It is important to support workers who are willing to make an effort to assume a better job on their own, through proactive policies that make it easier for nonregular workers to become regular workers and also through policies that provide vocational education and training,” it says.

Universities or other higher educational institutions are urged to offer services that enable students to acquire practical job-related knowledge and skills, along with conventional academic services.

Assuming freeters and other nonregular workers maintain their current status, the income they would lose by not being able to become regular workers will account for almost 1 percent of gross domestic product, the Cabinet Office said.

In May, the unemployment rate for men age 15 to 24 was 9.5 percent, while the rate for women in the same age bracket was 7.2 percent.

The overall jobless rate was 4.0 percent for the month, which was the lowest reading in eight years, according to government data.

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