By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is expected to sharply cut its economic forecast for the current fiscal year due to last month's devastating earthquake but project a rebound in the autumn, signaling that it has eased monetary policy enough to keep the economy afloat at least for now.
The central bank will nudge up its consumer price forecasts in its twice-yearly outlook report to reflect recent rises in commodity costs, but stress that supply-driven inflation alone would not shake its commitment to ultra-easy policy.
The nine-member board is set to hold off on additional monetary easing steps and announce details of a new loan scheme targeting quake-hit banks, which was unveiled at its previous rate review.
Here are possible outcomes from the meeting:
POLICY ON HOLD, STICK TO RECOVERY FORECAST POSSIBILITY: HIGHLY LIKELY
Reflecting an expected slump in factory output from supply constraints since the quake, the BOJ will cut its economic forecast for the 2011/12 fiscal year, which began on April 1, from its January projection of 1.6 percent growth.
But the BOJ sees little need to ease policy immediately as it expects the economy to pick up by autumn, when supply chain disruptions and damage to output from power shortages ease.
Exports have sunk and business sentiment has worsened sharply since the quake, while output likely posted a record fall in March.
The BOJ eased policy just days after the March 11 disaster, however, and feels it has already responded pre-emptively to the damage to growth.
In the semiannual report, the BOJ will stick 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 board's median economic forecast for the current fiscal year will likely be cut to somewhere between 0.5 percent and 1 percent, roughly in line with a 0.7 percent projection by analysts polled by Reuters earlier this month.
The BOJ will likely forecast a rebound in growth in the following year that exceeds its January projection of 2.0 percent.
MARKET REACTION: Bond yields and the yen may briefly fall if the BOJ cuts its growth forecast much more than anticipated, fuelling expectations of a near-term monetary easing.
STRENGTHEN EASY-POLICY COMMITMENT POSSIBILITY: LIKELY
The BOJ has pledged to keep interest rates virtually at zero until Japan achieves long-term price stability, which the board "roughly" defines as consumer inflation of 1 percent.
The central bank will consider tweaking the definition to specify a median 1 percent consumer inflation forecast by the board's members, signaling that this would be more or less a target to be achieved for the stimulus to be unwound.
It may also stress -- either in the twice-yearly report or at Governor Masaaki Shirakawa's post-meeting news conference -- that an unwinding of its ultra-loose policy would be considered only when price rises are driven by economic growth and not just by a spike in food and fuel costs.
In this way, the BOJ would seek to dispel speculation that it might be tempted to reverse its ultra-easy policy if rising fuel and food costs push consumer prices toward the 1 percent mark.
Recent rises in commodity prices will likely prompt the BOJ to revise up its forecast for core consumer inflation this fiscal year to around 0.5 percent from 0.3 percent. It may also raise its 0.6 percent consumer inflation forecast for the following year by a few percentage points.
MARKET REACTION: Markets are unlikely to move much as few expect the BOJ to unwind its ultra-easy policy any time soon.
EASE POLICY POSSIBILITY: HIGHLY UNLIKELY
The BOJ stands ready to ease policy further if damage from the quake and tsunami, which triggered a protracted nuclear safety crisis and a power crunch likely to persist through the summer, threaten the economy's return to a moderate recovery.
But the central bank 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 data for these months has been released in July.
For the time being, the BOJ will focus on measures aimed at encouraging banks to lend more to companies hit by the quake.
It will announce details of a 1 trillion yen ($12 billion) loan scheme 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 kick off the loan program in May and will be ready to expand it in coming months if demand for loans proves greater than expected, sources familiar with the central bank's thinking said.
MARKET REACTION: The surprise move would push down bond yields and the yen.
($1 = 81.845 Japanese Yen)
(Editing by Edmund Klamann)