The yen surged more than 1 percent against the dollar after the central bank beefed up the supply of fixed-rate loans to banks, a move investors saw as a symbolic gesture that will do little to halt a climb in the currency that hurts exports and may prolong deflation.
Government officials, increasingly alarmed by the yen's rise that took it to a 15-year high against the dollar last week, have tried to talk down the currency while leaning on the central bank to help by further relaxing its policy.
Now, the BOJ's cautious move at an emergency meeting held a week ahead of a scheduled review put the ball back in the government's court and market players may test its resolve to back its words with yen-selling intervention, analysts said.
Today's move is not a bold move, said Simon Wong, regional economist at Standard Chartered Bank in Hong Kong.
If the yen continues to appreciate, say it appreciates beyond the 80 level, that could trigger more direct intervention at some point.
In a statement after a meeting on economic steps to help keep the recovery on track, cabinet ministers said the government would watch currency moves carefully and take decisive action as needed -- a phrase seen as code for possible intervention.
Japan is facing a rise in the yen and there are concerns about a slowdown in overseas economies, Prime Minister Naoto Kan told a meeting of ministers with economic portfolios.
Japan's economic growth slowed to a crawl in the second quarter as exports to the United States and China ebbed and stimulus-driven consumption petered out. Analysts expect growth to slow further later this year, with the yen's surge to a 15-year high against the dollar adding to the pain.
MARKET PLAYERS DISAPPOINTED
Market players were disappointed that the BOJ failed to act more aggressively and, for example, increase Japanese government bond purchases or cut its benchmark rate from 0.1 percent to zero.
BOJ Governor Masaaki Shirakawa told a news conference the current level of bond buying was appropriate, but hinted at possible further action by raising the possibility of a downgrade in the central bank's economic forecasts.
The yen's rebound pulled the Nikkei share average off its peaks and helped Japanese government bond futures bounce back from an early plunge.
Kan, whose Democratic Party swept to power a year ago but was thrashed in a July upper house poll, is keen to show that he is doing something about the economy ahead of a challenge from powerbroker Ichiro Ozawa in a September 14 party leadership vote that could split the party.
Kan, his fiscal options constrained by a public debt worth twice the size of the economy, said the government would use 920 billion yen (7 billion pounds) in reserve funds to pay for steps that include jobs-related measures and deregulation.
But he added that an extra budget for the current fiscal year to March 31 would be compiled if needed.
Japan would probably have to intervene alone if it were to step in to curb yen gains, as its Group of Seven counterparts, happy with the benefits to exports from their weak currencies, are in no mood for coordinated intervention.
Solo currency intervention, however, will not have much effect in weakening the yen unless backed by aggressive monetary easing, traders say.
In Monday's move, the central bank increased the volume of money available to banks under its fixed-rate fund supply operation to 30 trillion yen from 20 trillion yen.
It also put in place a six-month fund operation in addition to the three-month loan programme already in place.
Of the 30 trillion yen, 10 trillion yen will be the six-month fund operation, the BOJ said. The decision was by an 8-1 vote, with board member Miyako Suda dissenting.
The central bank, as widely expected, maintained its overnight core rate target at 0.1 percent by a unanimous vote.
The BOJ launched the funding scheme, which offers loans at 0.1 percent, in December. That failed to boost bank lending but helped to push the yen further away from a November high.
The BOJ last eased monetary policy in March, when it doubled the size of the fixed-rate fund supply tool to 20 trillion yen.
(Writing by Leika Kihara and Linda Sieg; Additional reporting by Tetsushi Kajimoto, Chisa Fujioka and Yoko Nishikawa; Editing by Edmund Klamann and Tomasz Janowski)