Despite inflation staying well above the Bank of Japan's 2 percent target, financial markets are skeptical about whether the central bank will make any changes to its ultraeasy monetary policy at its upcoming meeting.

Given this prevailing view, a shift in Japan's ultraloose policy could have wide-ranging repercussions, similar to when the central bank raised the 10-year yield cap to 0.5 percent in a surprise move in December to rectify market distortions.

BOJ Governor Kazuo Ueda was recently quoted by the media as saying the country was still far from stably achieving the bank's 2 percent inflation target, helping to reverse market trends triggered by growing speculation of a possible policy adjustment this month.

"In light of the risk that the BOJ may change its stance if it upgrades its inflation outlook, some investors had moved to sell bonds or buy the yen," said Masafumi Yamamoto, chief currency strategist at Mizuho Securities Co.

File photo taken on July 3, 2023, shows the Bank of Japan head office in Tokyo. (Kyodo) ==Kyodo

The yen has staged a comeback in the last two weeks after hitting a seven-and-a-half-month low of around 145 against the U.S. dollar at the end of June -- a level that sparks speculation about yen-buying intervention by Japanese monetary authorities.

The prospect of the narrowing of the interest rate differential between Japan and the United States also helped ease the yen's recent declines against the dollar and other major currencies, with the U.S. Federal Reserve now forecast to end its interest rate hike cycle sooner than originally expected.

At one point, the yield on the benchmark 10-year government bond rose to 0.485 percent, nearing the BOJ's 0.5 percent cap, amid expectations that it will modify or scrap its yield curve control program introduced in 2016 by Ueda's predecessor, Haruhiko Kuroda.

Under the program, short-term interest rates are set at minus 0.1 percent, while 10-year government bonds are guided to around zero percent.

The yen's appreciation also weighed on stocks, which had rallied to fresh 33-year highs on the back of exporters over the past few months. A firmer yen can weigh on stocks as it raises the prospect that companies' overseas profits will be smaller when repatriated.

But the July 18 remark by Ueda, who took the helm of the central bank in April, as well as media reports Friday that BOJ officials currently see little need to address the side effects of its yield curve control program, led the Japanese currency to once again weaken.

The yen was trading in the upper 141 range against the dollar as of late Friday in New York after rising to the lower 137 level on July 14.

Embroiled in a decades-long battle with deflation, the BOJ has stressed the need for robust wage growth to attain stable inflation of 2 percent, fearing a premature tightening of monetary policy would derail its efforts.

The BOJ's cautious approach is rooted in the belief that the risk of inflation falling excessively after a rate hike is more significant than the risk of inflation picking up if rates are not raised, analysts said.

"Japan has been fighting against deflation for a long time. It has been extremely challenging to lift deflation and keep (the economy) in a non-deflationary state. Hence, the lesson from the past suggests that having some level of inflation might be better than slipping back into deflation," said Yamamoto.

"The most likely scenario is that the inflation forecast will be revised upward in July, but there won't be any policy adjustments," Yamamoto added.

Makoto Sengoku, senior equity market analyst at the Tokai Tokyo Research Institute, said while the likelihood of a change in July is "decreasing rapidly," an adjustment later in the year cannot be ruled out depending on the yen's movements, which could put upward pressure on prices through higher import costs.

"While I don't think the yield curve control program will be abolished, Mr. Ueda has said before that changing the target for long-term interest rates is something that could happen at any time," he said.

But some market participants consider the time ripe for a policy shift as signs are finally emerging that companies are changing behaviors in place since Japan was in deflation.

Major firms this year have offered wage hikes of an average 3.58 percent in annual pay negotiations, marking the highest increase in three decades, while the core consumer price index, excluding volatile fresh food items, has stayed above the BOJ's target for more than a year.

The Japanese government has revised its inflation outlook upward, projecting that prices, including energy and fresh food items, will rise 2.6 percent in fiscal 2023 instead of the previous estimate of 1.7 percent.

From Japan's political perspective, a possible policy change later in the year would carry too much risk for equity markets, as a general election is likely to take place in the fall, analysts said.

The July 27-28 meeting has also been eyed as the optimal time for the BOJ to make a move, if any, as the Fed is largely expected to raise interest rates one last time this month before ending its rate hike cycle.

"The BOJ making changes (to its yield curve control program) in line with the Fed would minimize the impact on markets. If the BOJ were to act alone after the Fed has finished its rate hike cycle, it could potentially be disruptive in far-reaching ways," said Yukio Ishizuki, senior foreign exchange strategist at Daiwa Securities Co.

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