BOJ likely to lift inflation forecasts, debate tweak to yield cap

The Bank of Japan will likely revise up its inflation forecasts and discuss further tweaks to its bond yield control at its policy meeting on Tuesday, amid growing expectations the days of the controversial monetary tool are numbered. The Japanese yen climbed to a two-week peak against the dollar after the Nikkei newspaper reported on Monday that the BOJ would consider making adjustments to its yield curve control (YCC) at the two-day meeting ending on Tuesday.

One of the ideas the BOJ will consider at its meeting is to allow the 10-year Japanese government bond (JGB) yield to rise above a 1 per cent cap by revising its guidance to conduct unlimited bond buying operations to defend that level, the Nikkei said. While any such move could reduce the need for the BOJ to ramp up bond buying, it would also cement market expectations of a near-term end to YCC and negative interest rates, analysts say.

"Tweaking the bond-buying guidance will be the final step in the YCC modification process," said Ataru Okumura, a strategist at SMBC Nikko Securities. "The market's focus will shift to the timing of an exit from minus rates and subsequent rate hikes." The BOJ sets a target of around 0 per cent for the 10-year yield under YCC. Under criticism that its heavy defence of the cap is causing market distortions and an unwelcome yen fall, it raised its de-facto ceiling for the yield to 1.0 per cent from 0.5 per cent in July.

Since then, rising global bond yields and persistent inflation have put the BOJ in a tight spot with the 10-year JGB yield threatening to breach the 1 per cent cap. The 10-year bond yield rose to a fresh decade high of 0.955 per cent on Tuesday. Sources told Reuters last week the BOJ could debate further tweaks to YCC at the Oct. 30-31 meeting to relax its grip on the 10-year yield.

The BOJ is widely expected to maintain the 0 per cent target for the 10-year yield and that for short-term rates at -0.1 per cent. In fresh quarterly forecasts due after the meeting, the BOJ is likely to revise up its projections to show inflation hitting or exceeding its 2 per cent target this year and next.

But the bank is seen projecting slower inflation in 2025, reflecting weaker growth and uncertainty over next year's wage negotiations in Japan. Japan remains a dovish outlier among global central banks that have mostly hiked rates aggressively in recent years to combat rampant inflation. Despite repeated assurances by BOJ Governor Kazuo Ueda that ultra-low interest rates will stay, markets are already predicting a policy shift early next year.

Nearly two-thirds of economists polled by Reuters expect the BOJ to end negative rates next year. Inflation stayed above the BOJ's 2 per cent target for the 18th straight month in September. Surveys have shown heightening inflation expectations, which lower the real cost of borrowing. The decision comes just hours after data showed Japan's factory output rising 0.2 per cent in September, much slower than market forecasts for a 2.5 per cent gain, as sluggish Chinese demand squeezes manufacturers.