BOJ to debate rate hike timing as Fed opens door to cuts

By Leika Kihara

TOKYO (Reuters) -The Bank of Japan will detail plans to taper its huge bond buying and debate the timing of a next interest rate hike on Wednesday, signalling its resolve to steadily unwind a decade of massive monetary stimulus.

The decision comes as the U.S. Federal Reserve looks to cut interest rates, possibly as early as September, reversing an aggressive rate-hike cycle that drove up the dollar and caused a painful yen sell-off for Japan.

Expectations of narrowing U.S.-Japan interest rate differentials have pulled the yen off 38-year lows, taking some pressure off the BOJ to slow the currency's drop by combining a rate hike with an ambitious bond-tapering plan.

But the yen's rebound also gives the central bank a chance to hike rates without giving markets the impression it is directly targeting yen moves through monetary policy, analysts say.

"The BOJ can move either way. If it wants to hike rates now, it can say consumption will rebound due to higher wages," said Yoshiki Shinke, senior executive economist at Dai-ichi Life Research Institute.

"If it wants to play it safe, it can await more data. Either way, the consumption outlook holds the key."

While the BOJ insists it does not use monetary policy to affect currency moves, rising concern over a weak yen has prompted some calls from government and business leaders for the central bank to speed up its shift away from near-zero rates.

At the two-day meeting ending on Wednesday, the BOJ will decide on a quantitative tightening (QT) plan that will likely halve monthly bond buying in 1-1/2 to two years' time - a pace roughly in line with dominant market forecasts.

The board will also debate whether to raise short-term rates from 0-0.1%, which could be a close call as policymakers remain split on how long they should scrutinise data before pulling the trigger.

More than three-quarters of economists polled by Reuters on July 10-18 expect the BOJ to stand pat. Money markets are pricing in a 64% chance of a 10 bps hike.

The BOJ's decision will come hours before that of the Fed, which is likely to hold rates steady before cutting rates as soon as September.

RECOVERY DOUBTS

Japan's economy is at an inflection point with core inflation holding above the BOJ's 2% target for well over two years and workers getting their biggest base pay hikes in three decades.

But rising living costs have hurt consumption, pushing the economy into contraction in the first quarter and casting doubt on whether households can swallow further price increases.

Still, with inflation keeping real borrowing costs low, the BOJ will likely drop signs that it is on course for a steady rate hike path through 2026 to remove what it sees as excessive monetary support.

Such clues, or guidance on the future rate hike path, will likely come from Governor Kazuo Ueda's post-meeting briefing or a quarterly outlook report due after the meeting.

In the report, the BOJ will likely roughly maintain its projection made in April that inflation will stay around its 2% target in coming years, sources have told Reuters.

Ueda has said the central bank will hike rates further if it becomes convinced that rising wages will prop up services inflation, and keep inflation durably around its 2% target.

Such projections are not without pitfalls.

The yen has surged from around 162 per dollar in mid-July to roughly 153 per dollar, its biggest two-week gain of the year. If yen rises continue, that could ease inflationary pressure from import costs in coming months.

There is also uncertainty on whether one-off tax cuts and rising wages will change households' frugal spending, as the BOJ projects.

Household spending unexpectedly fell in May and service sector sentiment worsened to levels unseen in nearly two years.

"On the surface, inflation may appear to be overshooting. But the underlying factors driving price moves aren't very strong," said former BOJ board member Takahide Kiuchi, who is currently an economist at Nomura Research Institute.

"I don't see evidence that backs up the BOJ's view that demand-driven inflation is accelerating steadily towards 2%."

(Reporting by Leika Kihara; Editing by Sam Holmes)