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BOJ tools include YCC, bond buying, interest rates

The Japan flag is juxtaposed against a Japanese yen bank note.

Javier Ghersi | Moment | Getty Images

Bank of Japan policymakers will gather in Tokyo next week for their penultimate meeting this year.

Market observers expect them to raise their inflation projections, while others think further modest adjustments to its yield curve control policy might be in order.

The Japanese central bank though, has a penchant for surprise — even if it’s notoriously cautious in unwinding its long-held ultra-loose monetary policy, wary that any premature move would jeopardize recent nascent improvements.

After all, the BOJ’s most recent tweaks in the last 12 months — which saw the central bank loosen control of 10-year Japanese government bond yields in December and again in July — surprised investors and rocked markets.

Investors have since been looking for clues on the BOJ’s next step toward rate normalization.

Policymakers meet eight times a year to decide on the bank’s monetary policy position, updating its economic outlook at every other meeting.

At these meetings, the BOJ policymakers decides on its monetary policy position, which then dictates how the central bank taps the money market.

This involves, among other things, supplying funds to financial institutions by extending collateral-backed loans to them. To absorb funds, the Japanese central bank issues and sells bills.

The BOJ’s monetary policy is complex and multi-faceted due to the various quantitative easing tools it has used to reflate the world’s third-largest economy in the last three decades.

Its super-easy posture also sets it apart as an outlier at a time when other major central banks have raised rates to combat the scourge of stubbornly high inflation. This policy divergence has partly accounted for various pressures on the Japanese yen and government bonds.

Here’s how the Bank of Japan conducts its monetary policy.

Price stability mandate

Bank of Japan could surprise in its upcoming meeting, strategist says

Core CPI slowed to 2.8% in September from 3.1% in August, dipping below the 3% threshold for the first time in over a year. Meanwhile, “core core inflation” slowed to 4.2% in September from 4.3% in August.

For the BOJ, the preference is for inflation to be driven by domestic demand, which is more sustainable and stable. The bank believes wage increments would translate to a more meaningful spiral, encouraging consumers to spend.

Japan’s umbrella labor union, Rengo, said Oct. 19 that it would demand wage hikes of at least 5% at next year’s spring wage negotiations, referred to locally as “shunto.” The union managed to secure the biggest raise in three decades at this year’s talks in March.

Negative rates

Japan's exit from ultra-easy policy 'may not come as early,' says Daiwa Securities

Yield curve control

Another key element of the BOJ’s unconventional monetary policy is its yield curve control — popularly known as the YCC.

Introduced in September 2016, the YCC is a policy tool where the Japanese central bank targets a longer term interest rate in the form of government bonds with specific tenures, and then buys and sells bonds as necessary to achieve that target.

The BoJ doesn't want to deliver a 'rate shock' to the economy: Investment management firm

Recent moves to loosen control over JGB yields have revived interest in the asset class, but it also sparked fears that Japanese investors may start to unwind investments overseas if yields are more competitive in their home markets. This could potentially be seismic for global financial markets.

“I worry as the yield curve normalizes and rates go up, you could see a decade — or longer — of repatriation,” Bob Michele, global head of fixed income at JP Morgan Asset Management told CNBC’s Squawk Box Europe Sept 21. “This is the one risk I worry about.”

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