Explained | What will BOJ's quantitative tightening look like?

The Bank of Japan may offer guidance on how it plans to reduce its $5-trillion balance sheet at its policy meeting on Friday, in a slow but steady retreat from its massive monetary stimulus.

Below are possible ways the BOJ could move to quantitative tightening (QT), and scale back a balance sheet that has ballooned to nearly 1.3 times the size of Japan's economy after years of aggressive monetary easing.

What is the BOJ's current plan?

Since ending negative interest rates and bond yield control in March, the BOJ has pledged to keep buying roughly 6 trillion yen ($38 billion) of government bonds per month to avoid the policy shift from causing an abrupt spike in bond yields.

BOJ Governor Kazuo Ueda has said the bank will eventually reduce bond purchases, but offered no clues on the timing.

The topic was discussed by the board in April with some members calling for the need to reduce the bank's balance sheet including by slowing monthly bond buying, or lay out a plan at some point in the future.

What could the BOJ decide on Friday?

Sources have told Reuters the BOJ will discuss whether to taper, but that the decision would depend on market developments leading up to the meeting, including moves after the U.S. Federal Reserve's policy meeting on Wednesday.

With Japanese bond yields stable and the yen remaining on a weak note, the BOJ may decide to trim monthly purchases slightly from 6 trillion yen or lower the range at which it buys each month.

But given some board members are opposed to an early taper, the central bank may instead decide to offer only vague language committing to reducing future bond buying. Such pledges may be included in the BOJ's policy statement or made in comments from Ueda at his post-meeting briefing.

What's at stake?

With inflation exceeding its 2% target, the BOJ plans to raise short-term interest rates steadily to levels that neither cool nor overheat the economy - seen by analysts as being anywhere between 1-2%. That means hiking rates several times in coming years from the current range of 0-0.1%.

During the process, the BOJ must start reducing its huge balance sheet, which it estimates as pushing down long-term borrowing costs by around 1%, to ensure future rate hikes are effective in scaling back the degree of monetary support.

The BOJ has a long way to go. At 125% times Japan's gross domestic product (GDP), its balance sheet is five times the Fed's in ratio-to-GDP terms. That means it needs to start tapering fairly soon, analysts say.

What are the risks?

Japan's dire fiscal situation means the BOJ must avoid causing sharp yield spikes that would boost the cost of funding the country's huge public debt.

Years of heavy-handed intervention by the BOJ has made bond market participants accustomed to its huge presence, which means even slight signs of tapering could destabilise markets.

As such, the BOJ won't follow the Fed, which scaled back its balance sheet under a fixed, pre-determined schedule from a peak of nearly $9 trillion yen to $7.4 trillion as of March.

Instead, the BOJ will keep indicating how much bonds it will buy on a monthly basis and reassure markets that any tapering will be gradual. It will also maintain a pledge to intervene in the market if yield rises are too sharp.