The head of the Bank of Japan said the bank will act decisively in the event of renewed financial market turmoil, his strongest hint yet at fresh support for the economy that analysts say could involve buying more government bonds or a return to quantitative easing.
A government spokesman said quantitative easing will indeed be part of the talks when BOJ Governor Masaaki Shirakawa and Prime Minister Yukio Hatoyama meet this week, as the government leans on the central bank to act against deflation.
"We absolutely don't have any plan to prepare for exiting our easy policy," Shirakawa told business leaders in Nagoya, central Japan.
"We had some developments in financial markets last week. If we experience financial market turmoil again, the BOJ will act aggressively and decisively," he said.
Despite mounting pressure from the government, which is worried about the risk of another recession, the BOJ has said there is little it can do beyond keeping interest rates at the current 0.1 percent to push up prices.
But analysts say the BOJ will eventually be pressed to increase its government bond buying or revert to a quantitative easing policy of flooding markets with extra cash.
"It is likely the BOJ will do more. The most important measure is the BOJ's purchase of government bonds," said Simon Wong, a regional economist at Standard Chartered in Hong Kong.
"The current path paves the way for the BOJ to further ease in terms of buying of JGBs, and the current inflation environment creates a perfect backdrop to expand monetary policy."
Asked whether the BOJ could increase its bond purchases, Shirakawa said the bank will take the most appropriate policy action to deal with economic and financial developments at the time.
"The financial market is a living thing, so we'll always think of how best to maintain market stability," Shirakawa told a news conference. "We're in a position now to provide ample liquidity to the market."
He said he recognised the pain felt by Japanese companies from the yen's surge to a 14-year high against the dollar, adding that he would closely examine how currency moves affect the economy.
He said the BOJ held a very cautious view of the economy and shared the government's view that the country was in mild deflation in the sense that price falls are likely to persist.
INTERVENTION NOT RULED OUT
The government has declared Japan to be in deflation and has criticised as too optimistic the BOJ's view that annual consumer price falls will gradually ease and that another recession is unlikely.
Hatoyama's government, only two months old and largely untested on fiscal policy, has adopted the kind of heavy-handed approach towards the BOJ that previous governments have used to influence monetary policy.
But it has been vague on exactly what it wants the BOJ to do.
The administration is considering including measures to deal with the recent surge in the yen in an economic stimulus package it plans to compile this week.
Data on Monday showed industrial output rose 0.5 percent in October and manufacturers forecast further rises in the following two months, easing some concern that the economy could slow to a standstill or even contract early next year.
For a graphic on output click http://r.reuters.com/dam93g
But the yen's surge last week is hurting manufacturers' profitability and could derail an export-driven recovery.
Finance Minister Hirohisa Fujii left markets guessing on whether Tokyo would step into the currency market to stem further yen rises, warning on Monday that he had never said intervention was impossible.
Voter support for Hatoyama's cabinet is above 60 percent but has slipped gradually. The nightmare scenario for the cabinet is an economic downturn ahead of an upper house election in mid-2010.
A rebound in the manufacturing sector has been driving Japan's recovery since earlier this year. The economy grew 1.2 percent in July-September after a revised 0.7 percent expansion the preceding quarter.
