By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is set to keep monetary settings unchanged on Wednesday and signal its readiness to maintain its massive stimulus programme for the time being, as global trade frictions and financial market jitters cloud the economic outlook.
Reflecting growing concern over the pain years of near-zero interest rates are inflicting on bank profits, the BOJ may issue a slightly stronger warning on financial vulnerabilities in a quarterly report due out on Wednesday.
But any tweak in language on financial risks is unlikely to signal a near-term rate hike, as heightening external headwinds darken prospects for achieving the BOJ's 2 percent inflation target, say sources familiar with its thinking.
"For the BOJ, the focus is on how Japan's economy could be affected by risks like intensifying trade frictions, global stock adjustments and rising oil prices from heightening geopolitical risks," said Hiroshi Ugai, chief economist at JPMorgan Securities Japan.
"When the BOJ is looking at downside risks to the economy, it's unthinkable for the bank to take further steps that could lead to rises in long-term yields."
At a two-day rate review ending on Wednesday, the BOJ is expected to maintain a pledge to guide short-term interest rates at minus 0.1 percent and long-term rates around zero percent.
The central bank's nine-member board will also issue fresh growth and inflation forecasts in a quarterly report assessing the long-term economic outlook and risks.
The BOJ may slightly cut its growth and price forecasts for the current fiscal year ending in March 2019, but roughly maintain projections for the following two years.
Markets are focusing on how the BOJ's report could explain the rising cost of prolonged easing, with some central bank policymakers publicly warning of the pain years of near-zero rates are inflicting on financial institutions' profits.
People familiar with the central bank's thinking say it is considering changes to its government bond buying programme - which it uses to drive borrowing costs lower - to let the bond market better reflect fundamentals. That would address a common criticism that the BOJ's involvement in the market discourages secondary trading.
In a semi-annual review of Japan's banking system earlier this month, the BOJ said risk-taking in Japan's financial sector hit a near three-decade high and domestic banks saw core capital ratios decline as they struggle to earn profits.
Some analysts say the BOJ could reflect such findings and modify its view on financial risks in the quarterly report, which up till now had said banks were not taking excessive risks and had sufficient buffers to weather financial shocks.
But Shigeto Nagai, a former BOJ official who is now head of Japan economics at Oxford Economics, said it was hard for the BOJ to adjust policy solely to mitigate the pain on banks.
"To have a visible positive impact on banks' profits, the BOJ would have to do more than tweak policy," he said. "Interest rates would need to rise and the yield curve would have to steepen significantly, but macroeconomic prospects suggest that such a policy move is unlikely in the foreseeable future."
(Reporting by Leika Kihara; Editing by Sam Holmes)