BOJ to slow pace of bond tapering next year as fresh risks emerge

By Leika Kihara and Makiko Yamazaki

TOKYO, June 17 (Reuters) - The Bank of Japan kept interest rates steady on Tuesday and decided to decelerate the pace of its balance sheet drawdown next year, signaling its preference to move cautiously in removing remnants of its massive, decade-long stimulus.

Escalating Middle East tensions and U.S. tariffs are complicating the BOJ's task of raising still-low interest rates and reducing a balance sheet that has ballooned to roughly the size of Japan's economy.

BOJ Governor Kazuo Ueda said rising oil prices, if they persist, could affect underlying inflation in a way that could warrant action.

But he said there were bigger downside risks to Japan's economic and price outlook from uncertainty over U.S. trade policy, suggesting the bank would be in no rush to hike rates again.

"The fallout from trade uncertainty could weigh on companies' winter bonus payments and wage negotiations (with unions) next year," Ueda told a news conference, stressing the need to await more data in deciding the next rate-hike timing.

"Even if developments surrounding U.S. trade policy stabilise toward a certain direction, there's very high uncertainty on how that could affect the economy."

In a widely expected move, the BOJ maintained short-term interest rates at 0.5% by a unanimous vote at its two-day policy meeting that ended on Tuesday.

The central bank made no changes to an existing bond tapering plan, under which it will reduce government bond purchases by 400 billion yen ($2.76 billion) per quarter so that monthly buying slows to around 3 trillion yen by March 2026.

However, in an extended quantitative tightening (QT) plan decided on Tuesday, the BOJ will halve the quarterly reduction amount from fiscal 2026 so that monthly purchases fall to around 2 trillion yen by March 2027. That pace aligns with requests the BOJ received from several market players in meetings last month.

Hawkish board member Naoki Tamura dissented on that particular decision, calling instead to keep reducing purchases by 400 billion yen per quarter during fiscal 2026.

The slower balance sheet drawdown signals the BOJ's concerns about disrupting markets in the wake of last month's spike in super-long government bond yields.

While the move would delay progress in reducing the BOJ's huge balance sheet, it would put less stress on a market long dominated by the central bank's huge presence.

"Today's decision is market friendly," said Saisuke Sakai, senior economist at Mizuho Research & Technologies in Tokyo. "Slowing the pace of tapering would work to keep long-term rates from rising too much."

The BOJ said it will conduct an interim review of the fiscal 2026 taper programme at its policy meeting in June next year.

"In case long-term interest rates rise rapidly, the BOJ will respond nimbly, such as by increasing its bond purchases," the central bank said in the statement, adding that its JGB holdings will fall roughly 16-17% in March 2027 from levels in June 2024.

INFLATION PRESSURES

Last year, the BOJ ended its bond yield curve control and began tapering its huge bond buying. It raised short-term rates to 0.5% in January on the view Japan was making progress towards durably achieving its 2% inflation target.

But uncertainty over the economic impact of U.S. President Donald Trump's tariffs has put major central banks, including the BOJ and Federal Reserve, in a holding pattern. The Fed is likely to reiterate its patient stance while leaving interest rates unchanged in the 4.25%-4.50% range on Wednesday.

A slight majority of economists in a Reuters poll expected the BOJ's next 25-basis-point increase to come in early 2026.

The BOJ's policy normalisation is at a crossroads as U.S. tariffs threaten to hurt Japan's export-heavy economy, forcing the board to cut its growth and inflation forecasts on May 1.

Japanese Prime Minister Shigeru Ishiba and Trump on Monday failed to achieve a breakthrough that would cut or eliminate tariffs that threaten to hobble the export-reliant economy.

The escalating conflict between Iran and Israel adds to headaches for policymakers as it could muddle the price outlook by boosting crude oil prices and heightening market volatility.

But delaying rate hikes for too long could leave the BOJ behind the curve in dealing with inflationary pressure, as firms continue to pass on rising raw material and labour costs.

Japan's core inflation hit a more than two-year high of 3.5% in April, well exceeding the BOJ's 2% target, due to surging food prices.

"We still think that the Japanese economy is unlikely to slip into recession even if Trump tariffs cause it to slow," Nomura said in a research note last week, noting the economy is being driven by the service industry.

But Nomura added that pressure on the economy from the Trump tariffs is expected to intensify this summer. Ueda also said he expects the tariff impact to become clearer later this year.

"Given very high uncertainty, it's become even more important than in the past to look at a wide range of information" in setting policy, Ueda said.

($1 = 144.9100 yen)