The Bank of Japan is set to emphasise its intention to keep interest rates near zero for a long time on Friday, when its upbeat economic view may come under fire from a government worried about deflation and the chance of another recession.
Indeed, the government may declare Japan is officially in deflation the same day the BOJ announces the outcome of its latest policy review. That would put the onus on the central bank to justify its economic assessment and calm government concerns.
The BOJ is eager to avoid escalating tensions with the government, aware it may come under pressure in the months ahead to boost bond purchases to help curb rising yields as the government considers more debt issuance to support the economy.
The central bank is highly unlikely to announce any fresh policies after deciding last month to withdraw support for corporate finance at the end of the year.
Here are possible outcomes of the two-day meeting. The decision is expected sometime between noon and 2:30 p.m. (0300-0530 GMT) on Friday.
BOJ DEFLECTS CRITICISM OVER ITS ECONOMIC VIEW
Probability: High
Government officials have criticised the BOJ's economic assessment as too rosy, arguing that the economy could return to recession as job losses rise and wages fall.
The central bank likely won't change its economic view on Friday given it only upgraded its assessment a month ago.
But the government could keep the central bank on the defensive. Government representatives attending the policy meeting could reiterate their criticism that the BOJ is not doing enough to support the economy in contrast to a government that is considering loosening fiscal policy through an extra budget.
The government could also declare as early as Friday that Japan has slipped into deflation, the first such announcement in more than three years.
The BOJ is forecasting three years of price falls but any such announcement by the government could pile pressure on the central bank to do more to beat deflation.
Eager to avoid worsening relations with the government, the BOJ will likely underline its long-held position that it will keep its overnight call rate target at 0.1 percent for as long as needed.
It may also seek to gain understanding by emphasising that the BOJ will be on its guard against any downside risks to growth. But it won't commit to any new action as it doesn't see any imminent risk to its economic forecast.
Japan's economy grew at the fastest pace in more than two years in the third quarter. A 1.6 percent quarterly rise in capital expenditure came as a surprise to many BOJ officials, who expected spending appetite to be much weaker.
For a graphic on Japan, U.S. and Euro zone GDP, click:
http://r.reuters.com/car69f
Market impact: Reaction in the money market, bond yields will be limited as markets already expect the BOJ to keep rates low at least until 2011.
BOJ SIGNALS CHANCE OF ANOTHER RECESSION, LEAVES ROOM FOR ACTION
Possibility: Low
Many BOJ officials aren't necessarily optimistic about the outlook, with some forecasting zero growth to a slight contraction in the first half of next year when the effect of domestic tax breaks fades.
But they don't see enough evidence to conclude the global economy will falter again and push Japan back into a recession.
The government believes otherwise and warns that there is a real risk of Japan returning to recession. Government representatives may convey this view at the meeting.
Two government representatives attend BOJ policy meetings. They cannot vote but can request delays in policy decisions.
Market impact: A downgrade in the BOJ's economic view is highly unlikely. But such action could push down the shorter end of the yield curve on expectations that low rates will persist longer than expected.
BOJ SIGNALS MORE BOND BUYING, MONETARY EASING
Possibility: Highly unlikely
The government is mulling an extra budget to support the economy, but its hands are tied as bond yields rise on market jitters over Japan's huge debt burden.
Fitch has warned of the risk of a ratings downgrade if the government stretches its finances too far.
Fiscal concerns helped widen the two-year/10-year yield spread to a 3-1/2-year high of 121 basis points last week. Japan's sovereign five-year credit default spread widened to around 77 basis points early last week, its highest since April.
If bond yields shoot up on renewed worries over Japan's tattered finances, the government may pressure the BOJ to boost its bond purchases from the current 21.6 trillion yen ($242.5 billion) per year.
The BOJ has said its bond buying is aimed at funneling long-term funds to the money market, not at pushing down bond yields.
If government pressure heightens dramatically, however, the BOJ may shift course and consider increasing bond purchases.
But there is little chance of that happening anytime soon or of Governor Masaaki Shirakawa signaling such a possibility at his post-meeting news conference.
Market impact: Any sign the BOJ will absorb more bonds from the market may push down bond yields on receding fears of debt oversupply. But bond yields may rise instead if markets see the BOJ as caving in to government pressure and doesn't have full control over monetary policy.
