Japan's central bank is likely to debate easing monetary policy further at a meeting on Thursday after the yen rose to another record high and doubts mounted over whether Europe can forge a clear plan to tackle the euro zone debt crisis, sources said.
If the Bank of Japan acts, it will likely expand its 50 trillion yen ($660 billion) asset-buying program by around 5 trillion yen, sources familiar with its thinking said.
The Japanese economy is recovering from the devastating March earthquake and tsunami and the central bank has been counting on fiscal spending on reconstruction and demand from emerging markets to sustain the upturn.
However, the yen's renewed climb to record highs against the dollar and stock market losses -- driven largely by market concerns that Wednesday's European Union crisis summit will fail to produce a decisive solution -- are dimming Japan's economic outlook.
Many central bankers have hoped to save their limited policy options for later, the sources told Reuters, but in light of the latest market jitters the decision will be a close call.
The BOJ last eased policy by boosting its asset buying pool in August, acting in tandem with the Finance Ministry, which ordered Japan's biggest ever single-day currency intervention selling more than 4.5 trillion yen.
The impact, however, proved short-lived and the yen crawled back to trade close to its record highs.
This has been a source of deepening frustration for Japanese officials, who argue that a rallying currency is one problem too many for a nation grappling with a nuclear crisis, a $250 billion post-quake rebuilding effort and ballooning debt.
The yen's break to new peaks against the dollar last Friday and again on Tuesday prompted a barrage of warnings from Japanese authorities that they were ready to step in if speculators kept driving the currency higher.
Finance Minister Jun Azumi on Wednesday served dealers another warning after the yen climbed to 75.73 to the dollar in New York the previous day, saying he would not rule out any steps to curb currency speculation and had instructed staff during the morning to be prepared for all possible measures on foreign exchange.
He also hinted at possible concerted action with the central bank.
The BOJ shares our sense of crisis, so I'm sure they will take appropriate steps when necessary, Azumi said.
The yen was quoted around 76.10 to the dollar in early Tokyo trade while Tokyo stocks were down 1 percent <.N225>, reflecting market nervousness about the outcome of the EU summit.
The prospects for a comprehensive deal to resolve the euro zone debt crisis this week looked dim, with deep disagreement remaining on critical elements, including how to give the region's bailout fund greater firepower.
Investors fear that, without a clear solution, the sovereign debt crisis engulfing highly indebted nations of the euro zone periphery could trigger a banking crisis and a credit crunch similar to what followed the Lehman Brothers collapse in 2008.
Since September 2010, Japan has intervened twice on its own and once jointly with other Group of Seven rich nations to weaken the yen. But the effects of intervention have proved fleeting in the face of steady demand from nervous investors seeking highly liquid and relatively safe assets such as Japanese government bonds.
(Additional reporting by Stanley White; Writing by Tomasz Janowski; Editing by Edmund Klamann)