By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is expected to keep monetary policy steady on Thursday but will sharply cut its economic forecast for the current fiscal year and signal its readiness to ease further if damage from last month's earthquake proves bigger than expected.
Supply chain disruptions, power outages and damage to sentiment from a nuclear plant crisis have already hit the economy, which may contract in April-June for a third straight quarter.
But the central bank is likely to hold off on easing policy for now as it feels it acted pre-emptively with a monetary loosening just days after the events of March 11.
Still, the BOJ will likely stress that it will keep monetary policy ultra-loose and that it stands ready to act if damage from the disaster threatens Japan's return to a moderate economic recovery.
"BOJ Governor Shirakawa has said that the sharp downturn in the economy will be temporary," said Seiji Adachi, an economist at Deutsche Securities.
"I don't think the BOJ will ease policy this week. The BOJ has already introduced additional purchases of assets and it hasn't reached the limit of this program."
The BOJ board is widely expected to maintain the policy rate at a range of zero to 0.1 percent, and focus on debating a twice-yearly economic outlook report that serves as a basis for monetary policy decisions in the coming few years.
The Japanese central bank's rate review comes after the U.S. Federal Reserve signaled on Wednesday that it was in no rush to scale back its support for the economy with the labor market still on the mend.
EYES ON DOMESTIC DEMAND
Japan is facing its worst crisis since World War Two after the 9.0 magnitude earthquake and subsequent tsunami devastated its northeast coast last month, triggering a nuclear plant crisis and power outages that hit factory output.
The BOJ eased policy days after the quake by doubling funds set aside for purchases of a range of financial assets, and flooding banks with cash to keep lending rates steady.
If the central bank were to again ease policy, the most likely option would be to boost the asset buying fund again.
Reflecting a slump in output after the quake, the BOJ will cut its economic forecast for the 2011/12 fiscal year, which began on April 1, to between 0.5 and 1 percent, compared with its January projection of 1.6 percent growth.
But it is seen revising up its growth projection for the following year and sticking to its view that while uncertainty over the quake's impact is high Japan's economy will resume a moderate recovery next fiscal year.
The BOJ may also nudge up its consumer price index forecasts in a twice-yearly report to reflect recent rises in commodity costs, but stress that supply-driven inflation alone will not shake its commitment to an ultra-easy monetary policy.
Exports and retail sales have slumped, suggesting the effects of the disaster are already being felt in an economy that was just emerging from a lull.
But there are signs that domestic supply chains are on the mend. BOJ Governor Masaaki Shirakawa has said supply constraints may start to ease after the summer, and he hopes economic growth turns positive in the third quarter.
The BOJ feels there is little that monetary policy can do when supply constraints, rather than weak demand, are the main damper to growth -- as is the case now.
The next trigger for monetary easing would thus be fresh evidence that supply constraints are hurting domestic demand enough for the economy to undershoot the BOJ's forecasts.
The BOJ hopes to scrutinize the impact of the quake on the economy in April and May, so it may stand pat on policy until July, when data for those months will have been released.
For the time being it will focus on measures aimed at encouraging banks to lend more to companies hit by the quake.
It will announce on Thursday details of a 1 trillion yen ($12 billion) loan scheme unveiled earlier this month for banks in the quake-hit region, including the length of the program, which will be either six or 12 months.
The BOJ will aim to start the loan program in May and will be ready to expand it later if demand for loans proves greater than expected, sources familiar with the central bank's thinking said. ($1 = 81.515 Japanese Yen)
(Editing by Michael Watson)