Bank of Japan Governor Masaaki Shirakawa has been doing his best to keep in check expectations of major new stimulus by the central bank next week.
Three times during a week-long tour of the United States, Shirakawa stressed that monetary easing alone cannot beat deflation and that too much stimulus, in the form of quasi-fiscal policy, could have drawbacks. He walked a fine line between sounding the message that easy policy still has a role in supporting Japan's weak economy and warning of the risks of too much easing.
Sources familiar with the central bank's thinking have said the BOJ, when it meets on Friday, will consider an increase in asset purchases as way to give a further boost to the economy and to show its determination of achieving the 1 percent inflation target it set in February.
Investors sold yen when Shirakawa said in New York on Wednesday that the BOJ will continue to pursue powerful monetary easing by keeping interest rates at zero and continuing to buy assets to nudge down borrowing costs.
But that phrase was just a repeat of the BOJ's standard line on its existing ultra-easy policy. It was added by Shirakawa's staff who worried about a repeat of the kind of political reaction to a speech the central bank governor made in Washington last month. On that occasion he focused on the risks of easy policy and angered domestic lawmakers who thought he was not aggressive enough in beating deflation.
This week in New York and Washington, ahead of weekend meetings of the International Monetary Fund and the Group of 20 leading economies, Shirakawa spent most of two speeches arguing that deflation was only a symptom of the bigger ills plaguing Japan, such as its shrinking population and low productivity.
If the Japanese economy is to extricate itself from deflation and return to a path of sustainable growth under price stability, it requires both policies aimed at enhancing growth potential and supporting monetary stimuli, he said in New York on Wednesday.
A day later, he preached to an audience in Washington about the danger of keeping monetary stimulus in place for too long, citing Japan's failure to forestall an asset price bubble in the 1980s that led to a severe economic downturn when it burst.
At this critical juncture, we need aggressive monetary easing. That's without question, Shirakawa told an event at the Japanese embassy. But we can't continue this easy policy forever. At some point, we need to reverse monetary policy.
And on Saturday, he warned that keeping bond yields low could dull the sense of urgency among governments about dealing with their fiscal problems.
FOCUS AGAIN ON FED
To be sure, Shirakawa is the most sceptical member of the BOJ board about the benefits to the economy of further easing. Others appear ready to pull the trigger as they worry that Europe's lingering debt crisis could hurt global growth and revive demand for the safe-haven yen, pushing up the currency and hurting Japan's export-reliant economy.
One of his two deputies, Kiyohiko Nishimura, said in western Japan on Wednesday that the BOJ was ready to loosen policy further to support the economy, giving the strongest signal yet of additional stimulus since the central bank surprised markets by taking easing measures in February.
Still, Shirakawa is likely to be cautious about more extreme options that may be put on the table next week.
That reluctance could trigger a market backlash as investors who had sold the yen on expectations of more, bold BOJ stimulus could buy back yen on disappointment, hurting Japanese equities on the way.
Any such market reaction would wipe out the praise the central bank earned for weakening the yen with its February monetary easing, adding to already enormous pressure from lawmakers for it to do more to beat deflation.
Failing to act would be seen as a mistake by the BOJ. If they were to stop now in attempting to boost the economy, markets would punish them by returning the yen to danger levels again, said Tommy Molloy, chief dealer at FX Solutions in Saddle River, New Jersey.
The BOJ surprised markets in February by setting a 1 percent inflation target and boosting its asset-buying and loan program, under which it buys government bonds and private debt, by double the usual increment of 5 trillion yen ($61 billion) to 65 trillion yen.
Markets have already priced in another 5 trillion yen increase in asset purchases at the April 27 meeting, so the BOJ would need to pledge a boost of double that amount or extend the maturity of government bonds it buys under the scheme to five years from the current two-year timeframe to push down yields at the longer end of the curve and slash longer-term borrowing costs.
Given Shirakawa's remarks about the drawbacks of ultra-easy policy, the chance of the BOJ targeting longer-dated government bonds is small, said Izuru Kato, chief economist at Totan Research in Tokyo.
The scale of BOJ easing may depend also on the outcome of the U.S. Federal Reserve's policy-setting meeting on Tuesday and Wednesday, analysts say.
The Federal Open Market Committee, the U.S. central bank's policy body, is expected to take no new steps to boost the economy at the meeting, but Chairman Ben Bernanke may clarify the Fed's threshold for further stimulus at a news conference.
If next week's FOMC eases market expectations of imminent easing and helps weaken the yen, the BOJ can get away with just a 5 trillion-yen increase, Kato said.
But if there's no such 'good luck,' there's a good chance it will be an increase of double that amount.
($1 = 81.6050 Japanese yen)
(Reporting by Leika Kihara; Editing by William Schomberg and Leslie Adler)