By Tamiyuki Kihara and Leika Kihara

TOKYO, May 18 (Reuters) – Japan’s government is likely to issue fresh debt as part of funding for a planned extra budget to cushion the economic blow from the Middle East war, a government source with direct knowledge of the deliberations told Reuters on Monday.

Any additional debt issuance would further strain Japan’s already ‌worsening finances and may accelerate rises in long-term interest rates.

Such concerns pushed the yield on the benchmark 10-year Japanese government bond (JGB) to 2.8% on Monday, its highest since October ‌1996, and the 30-year yield to a record top.

On Monday, Prime Minister Sanae Takaichi said she had told Finance Minister Satsuki Katayama last week to start work on compiling a supplementary budget, a shift from previous remarks ruling out the chance of ​an extra budget.

The extra budget will focus on funding government subsidies to curb gasoline and utility bills, as surging oil prices caused by the Middle East conflict cloud the outlook for an economy heavily reliant on fuel imports from the region.

While the size of spending has yet to be worked out, the decision could cast doubt on the administration’s pledge to pursue a “responsible, proactive” fiscal policy.

“The about-face by Takaichi, who had been ruling out an extra budget all along, is making markets jittery and triggering a JGB selloff across the curve,” said Katsutoshi Inadome, senior strategist at Sumitomo Mitsui Trust Asset Management.

In a proposal to the ‌finance ministry, opposition party leader Yuichiro Tamaki called on Friday for an ⁠extra budget of about 3 trillion yen ($18.9 billion), which may serve as a benchmark for future debates on the size of spending.

“There’s a host of reason to sell JGBs but very few to buy,” Inadome said, adding that markets are starting to price in the chance of an extra budget to the ⁠scale of 5 trillion-to-10 trillion yen.

Finance minister Katayama, who is in Paris to attend the Group of Seven finance leaders’ gathering, said on Monday she was instructed by the prime minister to “minimise various risks,” when asked about the rise in long-term interest rates.

“That’s something I’m contemplating,” Katayama said when asked how the government would fund the extra budget. She did not elaborate.

Japan already curbs gasoline prices with subsidies and eyes tapping existing funds to revive ​subsidies ​for utility bills.

An extra budget would come on top of a record 122-trillion-yen budget for the fiscal year that ​began in April, which makes up the core of the dovish premier’s expansionary ‌fiscal policy.

Critics warn that more spending plans, coupled with slow interest rate hikes by the Bank of Japan, could fan inflationary pressure in an economy already seeing rising energy costs from the Middle East war and higher import prices from a weak yen.

Japan’s Nikkei stock average fell on Monday and the yen hit 158.97 per dollar, the weakest level since April 29.

“When countries like Japan and Britain contemplate fiscal stimulus, there’s a tendency for that to trigger a triple selling of shares, currencies, and bonds because their economic growth is weak and inflationary risks are high,” said Daisuke Uno, chief strategist at Sumitomo Mitsui Banking.

The extra budget will be compiled around June or July, when the administration will lay out plans to boost investment and details for a two-year freeze on an 8% levy on food.

BOJ ‌IN A TOUGH SPOT

The bond selloff would also complicate the BOJ’s decision on whether to raise its short-term policy ​rate to 1% from 0.75% at its next meeting in June.

At the June meeting, the BOJ will also review its ​existing bond tapering programme and unveil a new plan for fiscal 2027 onward.

The war-induced spike ​in energy prices, coupled with rising import costs from the weak yen, pushed Japan’s wholesale inflation to a three-year high of 4.9% in April, bolstering the ‌case for the central bank to raise rates as soon as next month.

While ​the BOJ tends to avoid shifting policy when markets ​are volatile, delaying rate hikes further could stoke already mounting fears it is behind the curve in addressing the risk of too-high inflation, analysts say.

Markets have priced in roughly a 70% chance of a June rate hike after a slew of recent hawkish signals from the BOJ and a split vote to the BOJ’s decision to keep rates steady in April.

Nearly ​two-thirds of economists polled by Reuters expect the BOJ to raise rates ‌in June.

“If inflationary risks heighten, there’s a chance the BOJ could raise short-term rates to 1.5% by the March end of the current fiscal year,” said Mari Iwashita, ​executive rates strategist at Nomura Securities. The 10-year yield could head towards 3%, she added.

($1=158.8900 yen)

(Reporting by Tamiyuki Kihara and Leika Kihara; Additional reporting by Mariko Sakaguchi, Yoshifumi ​Takemoto and Anton Bridge in Tokyo, Makiko Yamazaki in Paris; Editing by Shri Navaratnam and Sam Holmes)