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TOKYO: The Bank of Japan signaled that its quantitative tightening (QT) program in July could be larger than markets expect and could even be accompanied by a rate hike as it gradually unwinds its still-massive monetary stimulus.
The Bank of Japan’s hawkish hints over the past week underscore the pressure the central bank faces as the yen weakens again, with rising import costs threatening to push inflation well above its 2% target.
Three sources familiar with the central bank’s thinking said rate hikes are on the table at every policy meeting, including the July one, regardless of a market shock or a severe recession.
“Rates are clearly too low given the inflation picture,” said one of the sources. “A lot depends on incoming data, but a July rate hike is possible,” said another, a third source concurring.
The Bank of Japan kept interest rates around zero this month.
However, minutes from Monday’s meeting showed the committee discussed the need for a timely rate hike, with one member suggesting a move higher was possible to prevent cost pressures from pushing inflation too high.
This was largely interpreted as a sign that the central bank is preparing to take action in the near term.
Bank of Japan Governor Kazuo Ueda told reporters after the meeting that he did not rule out the possibility of raising interest rates next month.
A rate hike by the Bank of Japan at its July 30-31 meeting could have an outsize impact on markets as the central bank also intends to announce a detailed plan on how it will wind down its massive bond-buying program and reduce the size of its $5 trillion balance sheet.
Ueda said the Bank of Japan is likely to cut its bond purchases “substantially,” suggesting the reductions could be large to ensure markets are free from the shackles of yield curve control – a policy it abandoned in March.
Like other central banks, the Bank of Japan is focused on developing a quantitative tightening program that avoids causing an unwelcome spike in bond yields.
But concerns about yen weakness also require that the quantitative tightening program must be ambitious enough to avoid disappointing market expectations and triggering a sharp decline in the yen.
The trade-off means the BOJ is likely to announce a plan to cut monthly purchases at a steady, fixed pace while leaving some flexibility to adjust the pace as needed, the sources said.
While there is no consensus within the central bank on the details, one idea being brainstormed is a design similar to the Fed’s that would cut purchases mechanically but with more flexibility.
The BOJ could cut bond purchases by specifying a narrow range, rather than a fixed number. It could also include an “exemption clause” that would commit to slow or temporarily stop tapering if market volatility becomes too high, the sources said.
They said the central bank would gradually reduce various bond maturities in a way that did not distort the yield curve.
The Bank of Japan will hold a meeting with bond market participants on July 9-10 to gather their views on what programs are working, according to minutes of its June meeting. One central bank member said the move is aimed at ensuring the central bank can cut purchases “more significantly.”
Izuru Kato, chief economist at Todan Research and a veteran BOJ watcher, said the central bank must strike a balance between the need for exchange rate stability and the need for bond market stability.
For this reason, it may consider further cutting its bond purchases each quarter.
“If the yen continues to weaken, the Bank of Japan may reduce its bond purchases and raise interest rates at the same time in July,” Kato said. “Reducing bond purchases alone may not be enough to prevent the yen from falling further.”
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