The Bank of Japan faces a difficult monetary policy decision at its two-day meeting beginning Monday, as the yen could further weaken if a policy tweak is not delivered as is expected by some in the financial markets.

However, many BOJ analysts expect both ultralow rates and the newly set 1.0 percent limit for 10-year Japanese government bond yields to be maintained, even if the central bank raises its inflation forecasts for fiscal 2023 and 2024 as expected in its quarterly outlook report due out at the end of the policy meeting.

File photo taken in July 2023 shows the Bank of Japan's head office in Tokyo. (Kyodo) 

While the BOJ aims to keep borrowing costs at rock-bottom levels to achieve stable inflation backed by wage growth, 10-year yields have been climbing toward 1.0 percent and U.S. Treasury yields have also been rising as inflation has become entrenched.

Complicating the equation for the BOJ is growing uncertainty over the economic outlook due to the Israel-Hamas war and its ramifications for the Middle East and beyond.

After a spate of rate hikes, the European Central Bank held off on another increase last week. The Federal Reserve, which has aggressively tightened monetary policy, is widely expected to pause at its two-day policy meeting from Tuesday, likely leading the yen to strengthen.

The Japanese currency is hovering around the psychological barrier of 150 against to the U.S. dollar, in a reflection of the BOJ's divergent easing policy. The weakening trend is also driven by surging U.S. Treasury yields, keeping financial markets on edge over a possible fresh round of yen-buying by Japanese authorities.

The yen's weakness is also causing headaches for Prime Minister Fumio Kishida, who plans to draw up a set of relief measures to assist households struggling to cope with rising prices of everyday goods driven by inflated import costs.

Under its yield curve control program, short-term interest rates are set at minus 0.1 percent while 10-year yields are guided to around zero percent. But the BOJ has made it less rigid, allowing 10-year yields to better reflect economic fundamentals as long as the yield remains below 1.0 percent.

The decision to expand the trading band in July came after the central bank was forced to face the reality that the yield cap program was accelerating the yen's depreciation due to it being out of step with the Fed and the ECB, among other global peers, which had entered a rate hike cycle.

The BOJ has maintained its dovish stance, however, underscoring the need to persist with ultralow rates because its 2 percent inflation target has yet to be achieved in the manner it desires. Governor Kazuo Ueda has cited uncertainty over whether wage hikes will be sustained, which is a requisite for the inflation goal to be met.

Some BOJ board members have become more confident in an outlook that predicts more price hikes next year, though Kishida has warned of Japan slipping back into deflation unless the nation can reverse the trend of inflation outpacing wage growth.

The BOJ currently forecasts an inflation rate of 2.5 percent for fiscal 2023 which it believes will slow to 1.9 percent in fiscal 2024.

The Japanese Trade Union Confederation has decided to demand a pay hike of 5 percent or more in the annual wage negotiations for fiscal 2024, broadly in line with its request for the current year.

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