Bank of Japan to stand pat even as trade war, dovish Fed cloud outlook

By Leika Kihara

TOKYO (Reuters) - The Bank of Japan is expected to maintain its massive stimulus programme on Thursday and signal its readiness to ramp up monetary support if growing risks such as the escalating U.S.-China trade war threaten the economy's modest expansion.

Many BOJ policymakers are wary of using their dwindling policy ammunition any time soon as years of ultra-low interest rates strain financial institutions' profits, say sources with knowledge of the central bank's thinking.

But the darkening outlook is also forcing them to brace for the likelihood of another economic downturn and brainstorm ideas on how to respond, they say.

Adding to the uncertainty are heightening market expectations the U.S. Federal Reserve will start to cut interest rates to fend off the damage from the trade war with China.

While such rate cut expectations have kept a floor on stock prices so far, an actual cut by the Fed could push down the dollar and trigger an unwelcome yen spike that hurts Japan's export-reliant economy, some analysts say.

"There may be no immediate need for action," one of the sources said. "But with uncertainty over the outlook so high, the BOJ would need to think about how to respond if a shock hits the economy."

At the two-day rate review ending on Thursday, the BOJ is widely expected to keep its short-term rate target at -0.1% and a pledge to guide the 10-year government bond yield around zero percent. The Fed meets this Tuesday and Wednesday.

The BOJ board is likely to maintain its view Japan's economy continues to expand moderately as a trend, but debate whether its projection of a rebound in overseas growth later this year remains valid, the sources say.

At a post-meeting news conference, BOJ Governor Haruhiko Kuroda is likely reinforce his view the central bank is ready to deploy additional stimulus if the economy loses momentum to hit its 2% inflation target.

Japan's economy expanded an annualised 2.1% in January-March but many analysts predict growth to slow in coming quarters as the U.S.-China trade row hurts global trade. A scheduled domestic sales tax hike in October may also cool consumption, they warn.

Many in the BOJ prefer to wait for more data, such as the central bank's "tankan" quarterly business sentiment survey due July 1, to see how deeply the trade tensions could hurt domestic demand, the sources say.

"Domestic demand, including capital expenditure, is still firm. The key is to see whether this will remain the case," a second source said.

Japan's annual core consumer inflation hit 0.9% in April, remaining distant from the BOJ's target, despite years of heavy money printing by the central bank.

Many analysts say the BOJ has very little tools left to fight the next recession, with its negative rate policy hurting financial institutions' margins and long-term yields already hovering below zero.

(Reporting by Leika Kihara; Editing by Kim Coghill)