The Bank of Japan is expected to ease monetary policy this week to support a fragile economic recovery if the yen continues to rise quickly enough to trigger currency intervention, sources familiar with the central bank's thinking said.
Even if Tokyo refrains from intervening, the central bank will consider easing if further yen rises or heightening uncertainty over the U.S. economy hamper Japan's recovery from the slump after the March 11 earthquake, one of the sources said on Monday.
The yen's overnight ascent near record highs against the dollar has heightened the possibility of Japanese currency intervention to weaken the yen, and for the central bank to follow suit with additional monetary easing.
The currency was trading at around 77.55 to the dollar on Tuesday morning, off Monday's peaks near its all-time high of 76.25.
If there is intervention, there is a strong chance the BOJ will ease policy, said another source, who spoke on condition of anonymity due to the sensitivity of the mater.
Some central bank officials are increasingly worried that the global slowdown and persistent yen gains are already hurting business sentiment and clouding the outlook for Japan's economy that largely relies on exports as an engine of growth.
But some in the BOJ are wary of acting just yet, given that Tokyo stock market is holding up relatively well and there is no hard evidence yet that the yen's climb is hurting corporate morale or capital spending plans.
Whether or not the BOJ will ease depends much on how sharp the yen rises, and whether the currency move triggers falls in Tokyo share prices big enough to hurt business sentiment.
BOJ Governor Masaaki Shirakawa and his deputy, Hirohide Yamaguchi, have both signaled that yen moves would be key in determining whether the economy needs more support from monetary stimulus.
Monetary easing becomes a near certainty if Japan's finance ministry, which has jurisdiction over currency policy, steps into the market to weaken the yen.
If yen rises are sharp enough, the BOJ may consider pushing forward its two-day rate review from the current Thursday to Friday, to ease policy, although the chance of this is small.
While the central bank maintains its view that solid global growth will help Japan's economy resume a moderate recovery in autumn, some board members believe the yen's climb poses a risk to such a scenario.
At least two of the nine board members had already signaled the potential need for further easing in recent rate reviews, according to minutes of the meetings. If the yen climbs further this week it may sway more policymakers in favor of policy easing.
If the BOJ were to ease policy, it would probably boost its 10-trillion-yen asset buying fund by 5 trillion yen to purchase more government bonds and private debt.
The BOJ would have to justify further policy loosening by altering its baseline scenario that Japan's economy is on course for a moderate recovery.
But some board members are not convinced yet it is necessary, given economic data have shown exports and factory output are rebounding and consumer sentiment is improving.
One concern is that if the BOJ eases policy to tame the yen it may soon face market pressure to do more -- something the central bank wants to avoid given its dwindling policy options.
(Additional reporting by Tokyo policy team; Editing by Tomasz Janowski)