TOKYO, July 26 (Reuters) - The Bank of Japan will consider next week taking steps to make its massive stimulus programme more sustainable, sources say, as new projections will show inflation falling short of its 2 percent target up to three years from now.
Below are possible options the BOJ could take at the rate review on July 30-31, based on conversations with sources familiar with the central bank’s thinking.
The BOJ guides short-term rates at minus 0.1 percent and the 10-year government bond yield around zero percent. The bank has essentially capped 10-year yields at 0.11 percent via market operations, despite insisting it has no set range in mind in guiding long-term rates around zero.
The resulting lack of volatility has led to a sharp decline in bond trading, stoking fears the BOJ’s huge presence is distorting prices and drying up market liquidity.
The BOJ will maintain its yield targets but tweak its policy statement to signal that it will conduct market operations in a way that allows for a natural rise in long-term rates.
Aside from government bonds, the BOJ buys risky assets including 6 trillion yen ($54.17 billion) of exchange-traded funds (ETF) per year as part of its stimulus programme.
Concerns have grown over the BOJ’s buying, however, as it reduced floating shares in the market and has put the bank on track to become a top shareholder of some big Japanese firms.
The BOJ could change the composition and purchase more Topix-linked ETFs instead of those linked to the Nikkei average, as the former consists of a wider variety of corporate shares.
The BOJ is unlikely to reduce the amount of ETF buying but may signal that the pace of purchases may slow ahead if markets are stable. It may also make operational tweaks to its buying of other assets, such as corporate bonds.
The BOJ could add a line in its policy statement that it is ready to act pre-emptively to mitigate risks associated with its stimulus programme, such as the hit to bank profits.
This would signal to markets that the BOJ could raise its yield targets in the future, if the cost of stimulus begins to outweigh the merits.
Despite shifting to a policy targeting interest rates in 2016, the BOJ keeps a loose pledge to increase government bond holdings at an annual pace of 80 trillion yen to appease reflationist board members who advocate heavy money printing.
Still, the BOJ has slowed its bond-buying pace to roughly half the amount of the pledge, as it can cap bond yields with smaller purchases due to its dominance in the market.
Removing the pledge will give the BOJ more flexibility in tapering purchases, and clarify to markets it is in no rush to achieve its elusive inflation target.
Reflationist board members may oppose the move. But they can be outvoted by the remaining six members, who see the pledge as no longer playing a key role in policy.
Many BOJ officials see the need to eventually hike the yield targets given the strain low rates are inflicting on banks.
But the BOJ will time such a move carefully and seek to give advanced warnings to markets to prevent market disruptions.
With inflation subdued and markets unstable on jitters over the U.S.-China trade tensions, the central bank is seen holding off on an actual rate hike for now. It may offer subtle hints to remind markets that a future rate hike is not off the table.
$1 = 110.7600 yen Reporting by Leika Kihara; Editing by Sam Holmes