The Bank of Japan said it was slightly more optimistic about economic and financial conditions on Thursday, likely bringing it a step closer toward phasing out some of its measures to support corporate funding.

BOJ Governor Masaaki Shirakawa told a news conference that improvements in Japan's corporate finance were spreading although financing conditions at small firms remained severe.

He said that the downside risks for the economy were lessening somewhat but that he remained cautious about the outlook.

Record deflation, rising job losses and weak capital spending all look set to cloud the debate on the timing for exiting its special measures, which include buying commercial paper (CP) and corporate bonds from banks.

Shirakawa's comments on improving corporate finance suggest the BOJ may end some of its corporate funding-support measures as they expire in December. But there's a chance it will keep them intact to avoid sending any negative message to markets, said Masamichi Adachi, senior economist at JPMorgan Securities.

The central bank's policy board voted unanimously to keep interest rates on hold at 0.1 percent, as widely expected.

The BOJ is understandably cautious about the remaining uncertainties to the economic outlook, but interest rates are as low as they can go and will likely stay there for some time, said David Cohen, director of Asian economic forecasting at Action Economics in Singapore.

The recent strength of the yen may also pose a problem for prices. Shirakawa said a stronger yen pushes prices down in the near term though it may support the economy in the long run.

BOJ officials will scrutinize the bank's closely watched tankan business confidence survey due on October 1 for clues on whether corporate sentiment and spending are improving at small firms as well as larger ones to help it decide when to phase out its unconventional steps.

The Reuters Tankan, a leading indicator for the BOJ's survey, showed on Thursday that manufacturers were at their least pessimistic in a year in September and expect conditions to improve further in the next three months.

The central bank may also be concerned about fiscal spending under the new administration of Prime Minister Yukio Hatoyama.

The BOJ is likely to err on the side of caution as it is unclear what policies the new government will undertake, said Naomi Hasegawa, a senior fixed-income strategist at Mitsubishi UFJ Securities.

Central banks around the world have begun debating how and when to phase out their emergency steps to contain the damage wrought by the worst global financial crisis in decades, but most are not expected to do so until well into next year.

The BOJ said exports and output were increasing thanks to a recovery in overseas markets, especially in emerging economies.

It maintained its view on prices, saying annual core consumer price falls would narrow in the latter half of the year to March 2010.

The central bank is widely expected to keep rates at 0.1 percent until at least March 2011.

The BOJ has extended its support measures for corporate funding, including buying commercial paper (CP) and corporate bonds from banks, to the end of December.

But the average issue rate for one-month CP fell to 0.21 percent in August from a peak of 1.34 percent last December, and there is a growing feeling at the BOJ that it could let some of its special steps expire in December without disrupting markets.

BOJ Deputy Governor Hirohide Yamaguchi said in a speech to financial industry executives on Thursday it was important to check the central bank's special measures were not hindering a recovery in market functions. But he added that credit costs for banks may keep rising.

Japanese exports and output have bounced back from a steep fall triggered by the global crisis, helping the economy return to growth in the second quarter.

A survey by the Ministry of Finance and the Cabinet Office also showed big manufacturers turned optimistic about business conditions in the three months to September compared with the previous quarter.

(Additional reporting by Izumi Nakagawa; Editing by Hugh Lawson)