By Leika Kihara
TOKYO (Reuters) -The Bank of Japan is set to keep ultra-low interest rates on Friday but may make minor tweaks to extend the lifespan of its yield control policy, which is facing scrutiny amid prospects of sustained inflation.
The Nikkei newspaper reported the central bank will maintain its 0.5% cap for the 10-year government bond yield, but discuss allowing long-term interest rates to rise above that level by a certain degree.
The move would be intended to fix distortions caused in markets by the BOJ's heavy bond buying, and accompanied by steps to combat any abrupt rise in long-term rates, the paper said without citing sources.
The yen strengthened to around 138.83 against the dollar in Asia on Friday, while the 10-year Japanese government bond (JGB) yield rose above the 0.5% ceiling.
"If the BOJ were to do as the Nikkei reports, it would essentially be eliminating the yield cap," said Naoya Hasegawa, senior bond strategist at Okasan Securities.
Under yield curve control (YCC), the BOJ guides the 10-year bond yield around 0% and sets an allowance band of 0.5% above and below that target.
While inflation has held above the BOJ's 2% target for more than a year, Governor Kazuo Ueda has vowed to keep ultra-loose policy until he is more convinced the economy can weather global headwinds and allow firms to keep hiking wages next year.
At the two-day meeting ending on Friday, the BOJ is widely expected to maintain the 10-year yield target and a -0.1% target set for short-term interest rates.
But sources have told Reuters the board may discuss making minor tweaks to the policy if the BOJ feels the cost of YCC is beginning to outweigh the benefits.
With wages and inflation on the rise, markets have been rife with speculation Ueda will soon phase out the radical stimulus programme of his predecessor.
Data released on Friday showed core consumer inflation in Japan's capital slowed in July but remained well above the central bank's 2% target, underscoring rising price pressure.
The BOJ's meeting comes after the Federal Reserve's decision on Wednesday to raise interest rates, a move that further widens the interest rate gap between the United States and Japan.
Any tweak to YCC could help prevent further declines in the yen, which would hurt households and retailers by pushing up the cost of food and fuel imports.
Since introducing YCC in 2016, the BOJ had little trouble controlling bond yields when inflation remained well below its target. That changed last year, when soaring commodity prices pushed inflation above the 2% target and gave investors reason to attack the yield cap.
After buying huge amounts of bonds to defend the then 0.25% ceiling, the BOJ last December widened the yield band and now allows the 10-year yield to rise by up to 0.5%.
The BOJ's quarterly growth and outlook report, due after the policy meeting, will offer clues on how convinced the central bankers are about prospects for durable inflation.
Nodding to broadening price pressures, the board is likely to upgrade its inflation forecast for the year that began in April from the current projection of 1.8%.
But the more important forecasts for fiscal 2024 and 2025 will likely remain largely unchanged from current projections, sources have said, reflecting uncertainty over the fallout from slowing global growth. The BOJ now expects core consumer inflation to hit 2.0% next year, before slowing to 1.6% in 2025.
Governor Ueda is expected to hold a news conference after the policy meeting.
(Reporting by Leika Kihara; Editing by Sam Holmes and Conor Humphries)
