The Bank of Japan said today it would not tolerate zero inflation or falling prices and promised to keep policy very easy, setting the scene for more action to fight deflation.
With deflation seen persisting and the government fretting about weakness in the economy, the BOJ may debate what options it has to loosen monetary policy early next year when the effect of domestic stimulus measures fades.
Lead 10-year Japanese government bond futures rose after the BOJ's anti-deflation message, taking gains to 0.35 point, as the central bank reinforced market expectations it would keep rates low for a long time and refocused attention on the potential for further monetary easing.
As widely expected, the BOJ kept its benchmark overnight call rate target at 0.1 per cent.
The government, in office for just three months, is determined to keep the economy from slipping back into recession ahead of an election for parliament's upper house in mid-2010.
But with Japan's public debt nearing 200 percent of GDP, room for fiscal expansion is limited. The government is now scrambling to trim spending for next fiscal year's budget to meet a symbolic bond issuance cap of 44 trillion yen
with rating agency Fitch warning of a credit downgrade if issuance far exceeds the target.
The BOJ is virtually alone in expanding monetary easing. The Federal Reserve said on Wednesday it would roll back some of its emergency lending facilities in February and the European Central Bank has said it will start phasing out extra liquidity operations.
At an emergency meeting on December 1st the BOJ decided to offer three-month funds to banks at 0.1 per cent, buying itself some space after weeks of pressure from the government to do more to support the economy.
The BOJ considers the new operation, which it described as quantitative easing in a broad sense, a powerful tool to push down the short end of the yield curve and hopes to use it as much as possible before embarking on further monetary easing.
Auctions of the new operation have met with strong demand, while three-month yen TIBOR has dropped to around 0.46 per cent from about 0.51 per cent at the end of November.
If Japan slips into another recession or concern over the country's huge public debt pushes up bond yields, the central bank may come under pressure for more aggressive action, such as increasing its purchases of government bonds.
The BOJ forecasts three years of deflation and has said it will keep monetary conditions accommodative for as long as needed. Headline consumer prices fell 2.5 per cent in October from the year earlier.
But the central bank has been reluctant to increase long-term government bond purchases from the current 21.6 trillion yen per year, arguing that the balance of its bond holdings is already nearing a self-imposed cap.
BOJ officials say the government first needs to reassure investors by coming up with clear and credible fiscal targets.
An increase in the BOJ's bond buying could push down the longer end of the yield curve. But the effect would be short-lived if the central bank sticks to its current stance of focusing its purchases on bonds that are close to maturity, analysts say.
Reuters