Pandemic reduces BOJ's options in backstopping frail economy

By Leika Kihara

TOKYO (Reuters) - The Bank of Japan is set to boost funding support for companies, but it will avoid cutting interest rates, sources say, as it could encourage people to step out of their homes to splurge and undermine government efforts to curb the coronavirus outbreak.

The dilemma for the BOJ underlines the difficulties of managing Japan's approach to controlling the spread of the virus, which lacks punitive measures applied in lockdowns of many Western countries.

At next week's rate review, the BOJ is expected to take further steps to ease funding strains for companies hit by the pandemic such as boosting purchases of corporate bonds and commercial paper (CP), sources have told Reuters.

More radical monetary easing steps to spur demand - such as interest rate cuts - are off the table as they could hamper government efforts to keep households home and businesses shut, said sources familiar with the BOJ's thinking.

"There's no doubt the economy is in a pretty bad shape. But taking steps to boost demand now would stimulate consumption and risk spreading the virus," one of the sources said.

The BOJ may need to take bolder easing steps to prevent bankruptcies and job losses from triggering a banking crisis, but such discussions will likely have to wait until the latter half of this year, a second source said.

"Debate on how to reflate the economy only kicks off when there's more clarity on when the virus will be contained," a third source said, adding that any steps the BOJ decides next week will be an extension of measures taken last month.

The BOJ eased policy last month by pledging to increase buying of risky assets and create a new loan programme to assist funding of small firms hit by the health crisis.

Among the measures taken in March included a pledge for the BOJ to spend up to 2 trillion yen ($18.56 billion) by September to increase its holdings of corporate bonds and CP.

"The BOJ may double or triple the amount (of such assets) it pledges to buy," said Tomoyuki Shimoda, a former BOJ official who is now an economics professor at Hitotsubashi University.

"Companies big enough to issue corporate bonds and CP probably have other means to procure funds, so it will be more a symbolic gesture to ease corporate jitters," he said.

At the two-day rate review ending on Tuesday, the BOJ is set to maintain its short-term interest rate target at -0.1% and a pledge to guide 10-year government bond yields around 0%.

NAIL IN COFFIN FOR KURODANOMICS

Major central banks have responded to the pandemic with aggressive monetary measures to cushion the broad hit to their economies. Many of the steps have been largely focused on calming market nerves and pumping ample liquidity into the financial system - rather than giving a direct boost to growth.

Japan's government last week expanded a state of emergency to include all of the nation. But it has struggled to contain the pandemic, as a lack of enforcement measures still keep many businesses open and trains running with commuters.

The number of infections reached 11,579 as of Wednesday with 283 deaths, according to public broadcaster NHK.

Japan's struggle to contain the pandemic is distracting the BOJ from its efforts to achieve its 2% inflation target. Up till now, the central bank has said it was ready to act if the economy loses momentum to achieve the elusive price goal.

That pledge is now out the window as the pandemic forces the BOJ to focus on immediate damage control, rather than achieving what has already become an obsolete target.

As the health crisis pushes the economy closer to recession, the BOJ is likely to sharply cut its growth and price projections in a quarterly review of its forecasts to be issued at next week's policy meeting.

The new projections will show inflation will remain distant from the BOJ's 2% target for the remaining three years of Governor Haruhiko Kuroda's tenure - marking the final nail in the coffin for his radical monetary experiment to pull Japan sustainably out of economic stagnation.

"Given the hit from the pandemic, the economy no longer has the momentum to achieve the BOJ's price target," said a fourth source. "But that doesn't matter now. The focus is squarely on how to deal with the current crisis."

($1 = 107.7400 yen)

(Reporting by Leika Kihara; Editing by Shri Navaratnam)