Preview: Bank of Japan to Keep 0.5% Policy Rate for 3rd Straight Meeting in Gradual Tightening Process, Focus on Pace of JGB Purchase Slowdown

(MaceNews) – The Bank of Japan is set to leave its policy interest rate for the third meeting in a row on Tuesday in a gradual tightening process amid the uncertainty sparked by the protectionist U.S. trade policy but the focus is on its mid-term review as to how drastically it should reduce asset purchases the next fiscal year.

At its June 16-17 meeting, the BOJ's nine-member board is widely expected to vote unanimously to maintain the target for the overnight interest rate at 0.5% for the third straight meeting amid uncertainty over the impact of trade conflicts on growth and inflation. In January, the panel voted 8 to 1 to raise the policy rate by another 25 basis points (0.25 percentage point) to 0.5% in its third hike during the current normalization process that began in March 2024.

The focus is on the bank’s mid-term review on how fast it should reduce the scale of its purchases of Japanese government bonds in the current fiscal year and onwards. The most likely scenario is to maintain the slowing pace of asset purchases by ¥400 billion a quarter for the current fiscal year ending in March 2026.

For fiscal 2026 starting in April 2027, the bank is expected to moderate the reduction pace, for example to ¥200 billion a quarter, to strike a fine balance between the need to normalize its policy stance (quantitative tightening) and the need to prevent the lower debt holdings by the central bank from jacking up long-term market interest rates more than necessary,

In July last year, the board decided in a unanimous vote to start reducing the pace of its purchases of JGBs gradually to around ¥3 trillion in the January-March quarter of 2026 from about ¥6 trillion then. In principle, it will reduce the pace by roughly ¥400 billion every quarter.

At the time, Governor Kazuo Ueda repeated that the overnight interest rate target remains the key policy tool, not changes to the bank’s asset holdings. The upward pressure on long-term interest rates will be limited as the bank’s outstanding JGB holdings will fall by only 7% to 8% in two years, he said.

By March 2026, the annualized rate of decline in JGB holdings by the central bank is estimated to be 7.2%, which does not seem to be so drastic, Takahide Kiuchi, executive economist at Nomura Research Institute, wrote in a report.

Kiuchi, who was a BOJ board member from 2012 to 2017, noted that since the BOJ decided last July to take a “gradual” approach toward unwinding its massive financial asset holdings, the annualized pace of whittling down JGB holdings was only about 3% from last July through April this year. This is much slower than a reduction rate of 10.4% in the first year of Federal Reserve’s own quantitative tightening that began in June 2022 as the U.S. economy had moved out of its pandemic doldrums and thus didn’t need much financial support. In its second year of balance sheet reduction, the Fed trimmed its Treasury security holdings by a faster 13.7% before slowing the pace to 5.5% in the third year, Kiuchi said.

However, if the bank continues trimming its JGB purchases by ¥400 billion a quarter from April 2026 through October 2027, following the previous 20-month frame from July 2024, when it began the “slow” process of quantitative tightening, until March 2026, the monthly amount of JGB purchases will plunge to ¥0.6 trillion in October 2027 and the annualized rate of decrease in JGB holdings will jump to 15.3%, Kiuchi estimates.

“That would even exceed the pace of reduction in Treasury securities holdings by the FRB in its second year (of QT) and I suspect that the substantially fast pace could destabilize the JGB market by triggering a rise in long-term interest rates,” Kiuchi warned.

In a June 7 speech, BOJ Deputy Governor Shinichi Uchida that traditionally the size of a central bank's balance sheet used to be determined largely by the amounts outstanding of banknotes in circulation and the reserve balance.

“However, many central banks now separate the size of their balance sheets from their guidance of short-term interest rates,” he said. “They do so because they have introduced a method of guiding interest rates in which they pay interest on current account balances.”

For his part, Governor Ueda emphasized that there is no need to change the pace of the BOJ’s balance sheet reduction, saying in his June 3 speech that the reduction of the purchase amount of JGBs “has been having its intended effects of improving the functioning of the JGB markets so far.”

“Many market participants pointed out that, although market liquidity declined temporarily from early spring due to the effects of tariff policies, the functioning of the JGB markets has been on an improving trend on the whole,” he said. “Thus, there are only limited calls for modification of the current reduction plan, which covers the period until March 2026.”

In considering what to do with the balance sheet reduction from April 2026, the governor stressed the importance of “striking a balance between predictability and flexibility.”

“From the viewpoint of ensuring predictability, it is appropriate for the bank to announce in advance a plan that covers a certain period of time,” Ueda said.

“On the other hand, given that the functioning of the JGB markets is still on its way to recovery and that price fluctuations have been seen since early spring, many participants expressed the need for a framework that continues to ensure flexibility,” he said, referring to late March and early April when President Trump announced stiff and far-flung tariffs on various goods that United States imports.

Ueda indicated that the pace of trimming JGB purchases in April 2026 could be any number. “Many market participants” expressed the view that it would be “appropriate” for the bank to continue to reduce its purchase amount of JGBs from April 2026, he said.

“That said, there were various opinions regarding the specific pace of reduction. Drawing from the experience of the reductions so far and taking into account the opinions from market participants, the bank will discuss, at the next MPM (monetary policy meeting), a guideline for its purchase amount of JGBs from April 2026,” Ueda concluded.

Kiuchi said the most likely scenario is to “slow the pace of JGB purchases while showing that the lower limit of monthly purchases will be around ¥1 trillion or around ¥2 trillion, and that the bank will stop reducing the purchase amount when it hits the lower limit during the next phase starting in April 2026.”

In its quarterly Outlook Report issued after the previous policy meeting on April 30-May 1, the board projected that underlying CPI inflation is likely to settle around the bank’s 2% target in the second half of the projection period (fiscal 2025 through fiscal 2027), which is about six to 12 months later than forecast earlier.

But Governor Ueda told a post-meeting news conference on May 1 that it “does not necessarily mean that the timing of the next rate hike will be pushed back in the same way.”

The BOJ appears to be still on course for two more 25 basis point rate hikes that would eventually take the overnight interest rate target to 1%. The bank is in the process of normalizing its policy by gradually lifting the rates that had been in a range of zero and slightly negative until March 2024.

Board members are closely monitoring whether high wage increases by major firms will spread to smaller firms in fiscal 2025 that began on April 1 (takes a few more months to see it hard data) at a time when real wages are depressed again, which could hurt consumption further and generate deflationary pressures.