The Bank of Japan is likely to debate easing monetary policy further at a meeting on Thursday after the yen rose to a record high and doubts mounted over whether Europe can forge a clear plan to tackle the euro zone debt crisis, sources said.
If the central bank acts, it will likely expand its 50 trillion yen ($660 billion) asset-buying program by around 5 trillion yen, sources familiar with the bank's thinking said.
BOJ Governor Masaaki Shirakawa, however, said the central bank was already buying massive amounts of government bonds to keep monetary conditions ultra-easy, countering views it was not doing enough to support the economy and suggesting that an easing on Thursday was hardly a done deal.
Japanese policymakers also continued their jawboning to keep markets from pushing up the yen further, although Japan's finance minister acknowledged that rallying G7 support for coordinated intervention to weaken the yen would be tough.
It would be very hard to forge a common interest and conduct joint intervention, Finance Minister Jun Azumi told Parliament on Wednesday.
We have been saying that in light of Japan's current economic situation, dollar/yen levels of 76 and 77 are inappropriate, he said, signaling that any intervention to stem sharp yen gains will be unilateral.
Japan's 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.
But the yen's renewed climb to record highs against the dollar are dimming Japan's economic outlook. The increase is being driven largely by safe-haven demand amid concern that Wednesday's European Union crisis summit will fail to produce a decisive solution.
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 will scrutinize the outcome of Wednesday's summit of European leaders, and its market fallout, in determining whether to act now rather than later.
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 yen rally 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 warnings from Japanese authorities that Tokyo was ready to step in to stem yen rises.
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 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 told reporters.
Expectations of BOJ easing pushed up Japanese government bond prices, while caution over possible currency intervention kept the yen hovering around 76.10 to the dollar in Tokyo.
But analysts doubt whether Tokyo is ready to sell yen at a big enough size to turn the tide.
Intervention is possible if dollar/yen falls to a new post-war low, but it would be a small amount of money, said Junya Tanase, chief strategist at JPMorgan Chase in Tokyo.
Japan isn't that willing to conduct intervention because of agreements with the G7. The comments officials are making today are more verbal intervention and may not have much meaning for Japan's currency policy.
The prospects for a comprehensive deal to resolve the euro zone debt crisis this week appear 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 G7 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.
($1 = 75.770 Japanese yen)
(Additional reporting by Stanley White, Rie Ishiguro and Tetsushi Kajimoto; Writing by Tomasz Janowski and Leika Kihara; Editing by Edmund Klamann and Matt Driskill)