By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is set to keep monetary policy steady on Tuesday and seek to allay speculation of an early tapering of its massive stimulus, as recent bond market turbulence puts to the test its revamped policy framework that aims to control the yield curve.
Japanese government bond yields spiked last week after the BOJ skipped a much-anticipated auction to buy short-term debt on Wednesday, leaving investors wondering about its intentions and casting doubt on its resolve to cap bond yields. Two days later, it surprised markets again by increasing bond purchases.
The BOJ says such adjustments to its market operations are aimed at getting markets accustomed to a decision it made last September, which was to shift its policy focus to interest rates from the pace of bond buying, sources say.
The central bank was forced into making the policy revamp after more than three years of aggressive bond buying failed to accelerate inflation to its 2 percent target.
But the new framework, dubbed "yield curve control" (YCC), has brought in new challenges. With markets accustomed to huge bond buying by the BOJ, any sign of slowdown in its purchases has heightened market volatility and prompted market speculation it could withdraw stimulus earlier than expected.
At a post-meeting news conference, BOJ Governor Haruhiko Kuroda is likely to stress that any tapering of the bank's huge asset-buying program would be some time off as inflation remains distant from its 2 percent target.
"Kuroda probably won't want to give markets the impression the BOJ is eyeing an early exit from its ultra-loose policy as that could turn around the current favorable weak-yen trend," said Izuru Kato, chief economist at Totan Research.
"The BOJ may consider raising its yield targets later this year, but only if yen declines become excessive and hurt households by pushing up grocery costs."
Markets are also focusing on what Kuroda has to say on uncertainty over U.S. President Donald Trump's economic policies and their impact on Japan.
Global bond yields have risen on expectations that Trump's pledge of big infrastructure spending could lead to higher U.S. inflation, putting upward pressure on Japanese long-term rates.
At the two-day rate review ending on Tuesday, the BOJ is set to maintain a pledge to guide short-term rates at minus 0.1 percent and the 10-year bond yield to around zero percent.
The BOJ is the first major central bank to commit to directly controlling long-term interest rates. The task has been made more difficult by a loose commitment it keeps to buy government bonds at the current pace, so that the balance of holdings increase at 80 trillion yen ($696 billion) per year.
UPBEAT ON INFLATION
The BOJ will also conduct a quarterly review of its growth and price forecasts at the two-day policy meeting. The bank's nine-member board is likely to raise its growth estimates for the coming years, as exports and output show signs of life on brightening prospects for the global economy.
But the central bank is likely to make only minor, if any, upward revisions to its already optimistic inflation forecasts despite external headwinds that push up prices, such as a rebound in oil costs and rising import prices from a weak yen.
Despite prospects of accelerating inflation, many central bankers remain wary on whether price rises driven by external factors could transform into sustained price growth backed by strength in the economy.
The BOJ now projects core consumer inflation to hit 1.5 percent in the fiscal year beginning in April and accelerate to 1.7 percent the following year.
Japan's economic growth remained anemic in the first half of last year as private consumption slumped, leaving many market players forecasting the BOJ's next move would be to ease policy.
But a pick-up in global demand has helped exports recover since late last year, heightening prospects of a stronger economic recovery. Some market players now bet the BOJ may hike its yield targets this year if inflation accelerates reflecting strength in the economy.
(Editing by Shri Navaratnam)