By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is expected to keep interest rates steady on this week and consider whether to offer clearer guidance on how it plans to reduce its huge balance sheet, in a slow but steady retreat from its massive monetary stimulus.
Policymakers may also debate recent weak signs in consumption, as they scrutinise whether Japan is making progress toward durably hitting their 2% inflation goal - a prerequisite for lifting interest rates from current near-zero levels.
Consumer sentiment soured for two straight months in May and service-sector morale fell to levels unseen in nearly two years, government surveys showed, casting doubt on the BOJ's view that prospects of higher wages will underpin household spending.
"Household sentiment is weak, which is worrying," said a source familiar with the BOJ's thinking, a view echoed by three more sources. "The weak yen may have weighed on consumer sentiment," a second source said.
At the two-day meeting ending on Friday, the BOJ is expected to keep its short-term policy rate target in a range of 0-0.1%.
The central bank may trim its bond purchases or drop clues on its future taper plan to soothe market jitters, caused in part by a lack of detail on how it will scale back its $5 trillion balance sheet, sources have told Reuters.
The decision will be a close call and depend much on market developments leading up to the meeting, including yen and bond yield moves after the U.S. Federal Reserve's policy-setting meeting concluding on Wednesday, sources say.
A Reuters poll showed nearly two-thirds of economists expect the BOJ to start tapering its monthly bond buying, now set around 6 trillion yen ($38 billion), on Friday.
The BOJ has said it will proceed gradually in tapering bond buying with a focus on avoiding any abrupt spike in yields.
However, a stubbornly weak yen complicates the BOJ's policy path.
The BOJ's decision to end negative rates in March has failed to reverse the currency's downtrend, driven largely by the market's focus on the huge U.S.-Japan interest rate divergence.
A weak yen is already hurting consumption by pushing up the cost of imports. While further yen falls could speed up inflation and justify hiking rates, they could cool consumption if wages fail to rise enough to make up for rising prices.
Some analysts say the BOJ could use quantitative tightening (QT) as a tool to slow the yen's falls by allowing long-term interest rates to rise more, a view the central bank denies.
While the BOJ expects scheduled tax breaks and higher wages to underpin consumption, some of its board members have voiced concern over the outlook.
Board member Seiji Adachi said in May it was hard to say the economy was in good shape, while fellow policymaker Toyoaki Nakamura said recent consumption has been stagnant.
"There's a chance inflation may not reach 2% from fiscal 2025 onward, if consumption slumps and discourages firms from raising prices," Nakamura said.
($1 = 157.2600 yen)