Bank of Japan to Stay Pat, but for How Long?

Bank of Japan headquarters in Tokyo, Japan
Tomohiro Ohsumi | Bloomberg | Getty Images
Bank of Japan headquarters in Tokyo, Japan

Recent calm in the Japanese equity and bond markets has led analysts to conclude that the Bank of Japan (BOJ) will not take bold action at its two-day meeting starting Wednesday.

However - in the absence of further policy action and stress in Asian financial markets over concerns that the U.S. Federal Reserve will soon taper its bond purchases - the BOJ could add to its $1.4 trillion stimulus announced in April, in the coming months.

"The recent calm in the markets will have increased the bank's confidence to keep its monetary policy steady at Wednesday's meeting," said Martin Schulz, senior economist at the Fujitsu Research Institute. "But they [the BOJ] could act again, if there was additional stress in the Asian markets," added Schulz.

(Read More: Kuroda Claims Success for Bank of Japan's Stimulus)

Prime Minister Shinzo Abe's radical plans to overhaul the Japanese economy, unveiled in mid-November last year, which include three arrows - aggressive monetary policy, fiscal stimulus and structural reform - have helped propel the Nikkei 66 percent higher and weaken the yen against the dollar by around 26 percent.

However, the Nikkei saw a sharp correction in recent months, falling 20 percent in the last week of May through to mid-June, amid the tapering panic. It has now recovered roughly 14 percent.

Schulz said another crucial factor for the BOJ going forward will be the outcome of the elections to the upper house of parliament on July 21. Abe is broadly expected to gain a majority, but if he fails to push through widely anticipated reforms quickly, the central bank may take action to reassure markets.

(Read More: How a Big Election Win for Abe Could Defeat Reforms)

"If the strengthened Abe government falls short on swift additions to the 'third arrow' of structural reforms by [not] announcing corporate tax cuts and deregulation, the BOJ might have to add additional stimulus to keep market sentiment from deteriorating fast," he added.

Junko Nishioka, chief Japan economist at the Royal Bank of Scotland also ruled out any action at Wednesday's meeting, arguing that the bank should be confident with the progress made in the Japanese economy. However, she acknowledged that the bank's next move was likely to be a bold one, rather than an incremental change.

"As the BOJ's outlook becomes more realistic, it will become more probable that the BOJ only takes a one-off big step as it did on April 4, rather than taking gradual steps," said Nishioka.

(Read More: Is an Overconfident BOJ to Blame for Market Woes?)

Since the central bank first unveiled its "bazooka" in April, the subsequent BOJ meetings have lacked any strong action. Market watchers were particularly disappointed last month, after it was expected the bank would take action to calm market volatility.

Kenji Abe, equity strategist at Citigroup Global Markets, said the BOJ was not likely to take action to stimulate the economy until October, when the next economic assessment was due.

(Read More: Latest Data Help Allay Doubts Over Japan's Policies)

He added that then the BOJ would "admit it's not going to meet its inflation goal of reaching 2 percent by the end of fiscal 2014 [which ends in March], and is therefore likely to ease monetary policy further."

In May Japan's core consumer prices did not fall for the first time in seven months. Meanwhile, the economy grew 1 percent in the first quarter from the previous quarter, translating into annualized growth of 4.1 percent.