Is the BOJ cornered?

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The Bank of Japan (BOJ) may be intent on keeping its easy monetary policy, but with the central bank poised to run out of bonds to buy, it could be forced into tapering next year, analysts say.

"Government related funds will be selling bonds to the BOJ for the remainder of the year, but that supply will run out towards the end of 2015," Bank of America Merrill Lynch rates strategist Shuichi Ohsaki told CNBC by phone. When that supply runs out, "the BOJ will have to change its current policy," he said.

Tasked with dragging Japan out of decades of deflation, for the past two years, the BOJ has been pumping massive amounts of liquidity into the economy by buying government bonds.

The quantitative easing (QE) program, first of 50 trillion yen ($413 billion) annually and expanded to 80 trillion yen last October, has driven a stock market rally, sent the yen plunging, and driven down interest rates across the curve. But so far, it has failed to stimulate much inflation at all, let alone hitting the central bank's targeted 2 percent rate.

The core consumer price index, the BOJ's preferred yardstick, hasn't even come close to two percent since 2013, peaking at 0.8 percent in February 2014; it came in at just 0.1 percent on-year in March 2015.

While the BOJ is expected to stick with its current policy at its meeting on Friday, the bond market may be just about tapped out. The central bank already owns a record 27.6 percent of the roughly 1 quadrillion yen of outstanding Japanese Government bonds (JGB), according to Japan Macro Advisors. If the BOJ continues to buy up bonds at the current pace, its share is set to rise to over 30 percent in 2015 and to 40 percent by the end of 2016.

After upbeat Q1 GDP, what will BOJ do?
After upbeat Q1 GDP, what will BOJ do?   

"The BOJ can probably find 80 trillion worth of bonds to buy this year, but they will start to struggle from 2016," Mizuho Securities market analyst Megumi Todo told CNBC by phone. "They will have to reduce the size of purchases," she said.

High tide

For the past year, the main source of bonds has been financial institutions related to the government, such as the Government Public Investment Fund (GPIF), the world's largest state pension fund, as well as the soon to be privatized Japan Post.

But the GPIF looks set to finish halving its bond holdings to 35 percent of its portfolio by the end of this year and Japan Post is fast depleting its stock of JGBs, analysts said.

Japan Post, which is slated for an initial public offering in September, has sold so much of its JGBs to the BOJ that its cash pile in December had more than doubled from its year-earlier level, reaching 30.7 trillion yen, according to BofA-ML's Ohsaki. Japan Post is the second-largest holder of JGBs, after the BOJ.

"Once the GPIF is done selling up, who will the BOJ buy bonds from," he asked.

Tight corner

With the supply of JGBs drying up, the question becomes what the BOJ can do going forward.

So far, Governor Haruhiko Kuroda has dismissed any attempts to discuss tightening monetary policy, although he has pushed back achieving the two percent target by a year, to sometime during fiscal year 2016.

But Kuroda's dogged devotion to his target will not cajole financial institutions into selling their JGBs to the central bank because they need to maintain a certain regulatory threshold, analysts say.

The BOJ could, like the ECB, charge banks to deposit money with the central bank, effectively imposing negative interest rates, or even more simply, cut the inflation target.

"The central bank could just concede that one percent is a more realistic target," said BofA-ML's Ohsaki.