By Leika Kihara and Tetsushi Kajimoto

TOKYO (Reuters) – Bank of Japan Deputy Governor Masayoshi Amamiya said bond yields should be allowed to move more “as long as it does not diminish the effect of monetary easing”, suggesting that steps to revive a nascent market will be discussed at next week’s policy review.

Amamiya said the BOJ must focus on keeping borrowing costs “stably low” for the time being as the economy suffers from the coronavirus pandemic, echoing comments made by Governor Haruhiko Kuroda on Friday.

But he added that fluctuations in yields could help breathe life back into a dormant market, as long as the moves were kept at a range that did not cripple Japan’s economy.

“A big fluctuation in interest rates could have undesirable consequences. But when it’s limited to a certain range, it’s possible to enhance bond market functions, without diminishing the monetary easing effect of our policy,” he said in a speech.

“Personally, I feel yields should be allowed to move more, as long as it does not diminish the effect of monetary easing,” Amamiya said in a question-and-answer session after the speech on Monday.

Benchmark 10-year Japanese government bond (JGB) futures dipped about 0.1 point after Amamiya’s comments.

Amamiya’s remarks underscore the communication challenge the BOJ faces as it seeks to meet two conflicting goals – to allow market forces drive yields more while avoiding a spike in borrowing costs that damages Japan’s recovery.

The BOJ caps the 10-year bond yield around zero under a policy dubbed yield curve control (YCC), and currently allows the benchmark yield to move 40 basis points around the target.

Allowing yields to fluctuate more around the target is seen as among key purposes of next week’s review, which aims to make the BOJ’s policy framework “more effective and sustainable”.

“The BOJ probably wants yields to fluctuate a bit more. But it also wants to set a speed limit on how rapidly yields could move,” said Mari Iwashita, chief market economist at Daiwa Securities. “The message from the review could be pretty fuzzy.”

RATE CUT A KEY TOOL

Japan’s 10-year yield fell to a three-week low on Friday after Kuroda said he saw no need to widen the implicit band set around the BOJ’s 0% target, stunning investors who had expected such a move to be announced at the policy review.

Amamiya said the governor likely expressed his personal opinion, adding the idea would be discussed at the review by the nine board members who had “various views” on the subject.

The review would also seek to dispel a dominant market view the BOJ has run out of ammunition to ease more, Amamiya said.

Interest rate cuts were among “important options” if the BOJ were to ease further, he said, stressing that it would take steps to mitigate the side-effects of such moves at the March review.

“Some market players think the BOJ can’t and won’t ease policy further due to the side-effects of its policy. We must dispel such views,” he said.

As for the BOJ’s risky asset buying, the BOJ would consider how to maximise the positive impact of such steps by pledging to buy exchange-traded funds (ETFs) and real-estate trust funds (REITs) aggressively in times of market shock, Amamiya said.

The BOJ will conduct a review of its policy tools at its rate-setting meeting on March 18-19.

(Reporting by Leika Kihara and Tetsushi Kajimoto; Editing by Ana Nicolaci da Costa, Lincoln Feast and Alex Richardson)