By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is expected to stand pat on monetary policy next week despite jitters over the recent jump in bond yields, hoping it can stem the volatility by fine-tuning market operations.
The central bank may front-load bond purchases or offer funds via market operations more frequently if the bond market turbulence persists, which are technical steps that can be taken by its bureaucrats without approval by the nine-member board.
It is expected to hold off on easing policy through further increases in asset purchases, having already pledged in April to double its bond holdings in two years to expand the supply of money at an annual pace of 60 trillion ($588 billion) to 70 trillion yen.
The recent bond selloff, which sent the 10-year yield to a one-year high of 0.92 percent on Wednesday, has highlighted the dilemma the central bank faces as it attempts to generate inflation in a country mired in price falls for 15 years.
"The BOJ is walking a very narrow path trying to engineer a gradual, not a sudden, rise in long-term rates backed by improvements in the economy," said an official with knowledge of the central bank's thinking.
The BOJ unleashed the world's most intense burst of stimulus last month, promising to inject $1.4 trillion into the economy in less than two years to meet its pledge of achieving 2 percent inflation in roughly two years.
By gobbling up 70 percent of the bonds newly issued by the government, it hopes to nudge Japanese investors out of the safety of bonds and into riskier assets like equities.
The rise in Tokyo shares to a 5-1/2-year high shows this may be starting to happen.
BOJ officials say they would accept a natural rise in long-term interest rates that reflect prospects of an economic recovery and future inflation.
But the intensity of the BOJ's purchases caused disruptions in the market by drying up liquidity, making bond prices vulnerable to sharp swings that could potentially lead to a damaging sell-off hard to control.
The pace of bond price falls and the huge volatility has made some central bankers nervous, but not enough to consider additional policy steps at the two-day policy meeting that ends on Wednesday next week.
LACK OF SOLUTIONS
Japan's economy expanded at an annualized 3.5 percent in the first quarter, the fastest in a year, offering evidence that Prime Minister Shinzo Abe's sweeping stimulus is beginning to work.
The BOJ may thus revise up its assessment of the economy to say it is picking up, compared with the previous month's view that it is "bottoming out with some signs of a pick-up."
But a sustained sharp rise in bond yields will hurt corporate capital expenditure, the soft spot of an otherwise more robust economy, and strain Japan's already tattered finances by boosting the cost of funding its huge debt pile.
Finance Minister Taro Aso appeared sanguine so far, telling parliament on Friday that it made sense for investors to shift funds out of bonds and into equities given recent sharp rises in Tokyo stock prices.
For now, the central bank hopes to use market operations to stem the volatility. It did so on Wednesday by offering to inject 2.8 trillion yen into the Tokyo money market, more than three times the size usually offered in a single day.
If volatility persists, the BOJ may also consider increasing the amount of bonds it buys each month from the current 7.5 trillion yen until bond prices stabilize, sources say.
But there is no guarantee that such minor tweaks in its bond-buying program can soothe market jitters for long. Wednesday's huge fund injection failed to prevent bond yields from ending higher for a fourth session.
Expanding stimulus, by pledging to increase bond purchases even more, could backfire by draining already thin liquidity in the market.
"The bond market has been distorted by the BOJ. It's reliant on central bank purchases more than ever, and a lack of liquidity will keep it vulnerable to sharp swings," said Masaaki Kano, chief Japan economist at JPMorgan Securities.
"The BOJ probably didn't expect so much volatility, and simply boosting its bond purchases won't solve the problem."
($1 = 101.9600 Japanese yen)
(Editing by Kim Coghill)