The dovish Bank of Japan faces a tough two-day policy-setting meeting from Thursday due to potentially changing inflation dynamics, with edgy financial markets seesawing over whether its controversial yield cap program will be modified.
The BOJ is widely expected to revise upward its earlier inflation forecast for the current fiscal year to next March, given more evidence that price hikes, initially prompted by surging fuel and raw material costs, have been broadening in a notable change for the once deflation-mired nation.
Financial markets are fixated on whether Governor Kazuo Ueda, who has warned of premature tightening, has grown more confident about the inflation outlook than before and the central bank would again allow long-term interest rates to trade in a wider range under its yield curve control program.
BOJ watchers say the central bank will likely retain its dovish stance and maintain monetary easing as Ueda has repeatedly said recent cost-push inflation will slow in the coming months and that sustained wage growth is a key factor for achieving the central bank's 2 percent price stability goal.
But headline inflation exceeding that target for more than a year, at least on the surface, the best outcome in about three decades of annual wage negotiations between labor unions and management, and rising expectations for entrenched inflation and robust wage growth appear to be gradually strengthening the case for the BOJ to tweak policy, analysts say.
The yen has been sold for the higher-yielding U.S. dollar and euro amid the policy divergence between the BOJ on the one hand and the Federal Reserve and the European Central Bank on the other. The Fed went ahead with a 0.25 percentage point hike on Wednesday as expected, with the ECB's policy meeting on Thursday.
Ueda has underscored the need to consider the time required for the impact of a policy decision to become apparent, saying that it would take six months to a year and a half.
"We have not moved toward monetary policy normalization because inflation will likely undershoot 2 percent. If that outlook changes greatly, it will lead to a policy change," the governor said in June.
Under the current BOJ projections unveiled in April, the core consumer price index that excludes volatile fresh food items, will increase 1.8 percent in fiscal 2023 and 2.0 percent in fiscal 2024. It is forecast to slow to 1.6 percent in fiscal 2025.
The latest policy meeting comes after Japan's inflation rate for all items exceeded that of the United States for the first time in about eight years in June. The Japanese government also raised its inflation forecast for the current business year to 2.6 percent from 1.7 percent earlier this week.
One of the viable options floated by BOJ watchers is to raise the cap on 10-year Japanese government bond yields to 1.0 percent from the current 0.5 percent.
The BOJ stunned financial markets in December by raising the upper limit from 0.25 percent, after a spike in bond yields driven largely by market players testing the central bank's resolve to defend it. Then Governor Haruhiko Kuroda explained that the change was meant to address its program's side effects that have kept borrowing costs extremely low.
The landscape appears to have changed since then, with the Fed seen as approaching the end of the current aggressive rate hike cycle that has sent the dollar surging against the yen. Monetary tightening in the United States and Europe has raised concerns about slower global economic growth, a negative for export-driven Japan.
Some BOJ watchers say the central bank cannot raise the cap for the purpose of addressing side effects this time, after Ueda took the view that yield curve distortions have been greatly rectified. The 10-year bond yield has been trading below the BOJ's 0.5 percent ceiling.
Still, financial markets are on edge following the December decision that came as a surprise.
Deputy BOJ chief Shinichi Uchida has acknowledged that enabling markets to factor in a specific change in advance is "difficult" under the yield curve control program. But he said in an interview in early July that the central bank would ensure appropriate communication and market stability within that framework.
