By Leika Kihara

TOKYO (Reuters) – The Bank of Japan’s surprise decision to loosen the grip on its yield cap marks the beginning of an end to Governor Haruhiko Kuroda’s controversial policy, sources say, and may pave the way for massive monetary stimulus to be phased out next year.

The central bank on Tuesday tweaked its bond yield control in a way that effectively allows long-term interest rates to rise more, shocking investors who weren’t expecting any such changes until Kuroda steps down in April next year.

The pressure for the BOJ to act now, rather than later, came from the government’s desire for more flexible monetary policy, prospects for higher wage growth and inflation and risks of a U.S. recession next year, say five government officials and sources familiar with the bank’s thinking.

How far the BOJ now goes depends on whether Japan’s economy can withstand headwinds from slowing global growth and if wages will perk up enough to support consumption, they say.

“The government’s view is that the BOJ should move nimbly and flexibly,” said an official with direct knowledge of the administration’s thinking, referring to how the BOJ’s consistent dovish tone had caused sharp yen falls that hit households via higher import costs.

While Kuroda explained the move as extending the lifespan of yield curve control (YCC), it underscored the BOJ’s resolve to gradually shift away from his radical policy ahead of a leadership transition when the governor’s term ends in April.

“Under a new governor, the BOJ could move further toward normalising policy and making its monetary framework more flexible,” said former BOJ board member Takahide Kiuchi, who is now an economist at Nomura Research Institute.

“Whether it can actually abandon negative rates or yield curve control next year will depend much on economic and financial conditions at the time,” he said.

The BOJ’s relentless defense of its 0.25% cap on the 10-year bond yield had forced the central bank to ramp up bond buying, dwindled market liquidity and distorted market pricing – strains that had become hard to ignore, the sources say.

By lifting the cap to 0.50% this month, the BOJ dealt with the immediate market stress and bought itself time to work out when it should step toward phasing out YCC, they say.

Waiting until next year would have forced the BOJ to combat intensifying market speculation of a near-term policy shift, or act when a deep U.S. recession could hit Japan’s economy, they say.

“The BOJ cleared one threshold toward phasing out stimulus,” said one of the sources. “When uncertainty is so high over the outlook for U.S. monetary policy, it probably wants to have a free hand on when next to act.”

POLITICS KEY TRIGGER

The abrupt timing of Tuesday’s move also reflects growing political pressure for the BOJ to shift away from a policy narrowly focused on its 2% inflation target, the sources say.

The groundwork was laid in a meeting between Kuroda and Prime Minister Fumio Kishida on Nov. 10, when the two agreed on the need to “guide policy flexibly” for sustained wage growth.

The agreement reflected the administration’s concern over the side-effects of the BOJ’s rigid defense of its low-rate policy, such as a yen plunge that was pushing up import prices and households’ living costs, some of the sources say.

“The premier and the BOJ governor met last month and talked about a flexible response,” one government official said. “That’s led the BOJ to act.”

Since then, the BOJ has dropped more hints of the chance of a policy tweak in a sign of a hawkish shift within the bank as Kuroda’s decade at the helm ends in April.

Hours before he met Kishida, Kuroda explained in parliament a framework on how the BOJ could exit ultra-easy policy in the future. One of his fellow board members, Naoki Tamura, told a recent interview the BOJ should conduct a review of its massive stimulus.

Another dovish board member, Asahi Noguchi, also said earlier this month it “won’t be surprising” for the BOJ to shift monetary policy.

The departure of Kuroda and his dovish deputy Masazumi Wakatabe, who had pushed back against steps to roll back stimulus, will likely leave the BOJ more open to contemplating an exit from ultra-loose policy, analysts say.

The growing public backlash against rising living costs could also affect Kishida’s choice of next BOJ governor, and tilt the central bank’s debate further toward ending YCC.

“If price hikes broaden, wages appear to rise more and Japan’s economy avoids a slump, the BOJ could engage in deeper discussion on whether to review its policy framework,” said a source.

Market players are bracing for more action next year.

“Even in Japan, inflation is now picking up, and there are some signs of acceleration in the wage growth, so I think the BOJ could conduct more steps approaching normalisation in the near future,” said Kentaro Koyama, Japan chief economist at Deutsche Bank.

“The next possible trigger for BOJ should be inflation and wage strength. We will have our spring wage negotiations next year, and in this negotiation, if we can get higher wage growth, I think it could be a trigger for the withdrawal of YCC.”

(Reporting by Leika Kihara; Additional reporting by Kentaro Sugiyama, Yoshifumi Takemoto, Takaya Yamaguchi, Takahiko Wada and Tetsushi Kajimoto; Editing by Sam Holmes)

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