The Bank of Japan offered banks more short-term funds after an emergency meeting on Tuesday, relieving government pressure on the central bank to help avert another recession before upper house polls next year.
Markets reacted with disappointment to the decision to offer 10 trillion yen in three month funds at 0.1 percent. Analysts said the funds would do little to tackle deflation, although by lowering yen lending rates, they may check the currency's rally.
The Prime Minister welcomed the move, suggesting the main outcome of the meeting was to mend fences with the government. By yielding to political pressure, the BOJ had left the door open to yet more demands as Japan grapples with the fallout of its worst recession on record.
This isn't the end of the story, said Richard Jerram, chief Japan economist at Macquarie Securities in Tokyo.
There are going to be more periods of government pressure and more periods of BOJ response.
Governor Masaaki Shirakawa, who holds talks with Prime Minister Yukio Hatoyama on Wednesday, said the decision had nothing to do with government pressure, and cast it as an attempt to contain the fallout of Dubai's debt woes.
We can say this is quantitative easing in the broad sense that we are trying to ensure banks are not faced with (liquidity) constraints, he said after the meeting, at which the BOJ left interest rates unchanged at 0.1 percent.
The finance minister had raised market expectations by talking openly of quantitative easing -- a policy of flooding banks with cash to stimulate lending -- which the BOJ pioneered as it tried to pull Japan out of deflation earlier this decade.
That, coming after weeks of government pressure and even accusations from one minister that the BOJ had fallen asleep at the wheel, prompted markets to anticipate a stronger policy response from the meeting.
SOMETHING MUCH BIGGER
The announcement of an emergency meeting took investors by surprise. As the global economy recovers from the credit crisis, most of the BOJ's peers are on hold. The European Central Bank may even begin unwinding ultra-loose policy this week.
Today's step is clearly not what many people would see as quantitative easing, said Takahide Kiuchi, chief economist at Nomura Securities in Tokyo.
I think markets wanted something much bigger.
The dollar fell against the yen and 10-year Japanese government bond futures trimmed gains as investors unwound positions they had taken after the meeting was first announced.
There will hardly be an impact on the real economy, said Hirokata Kusaba, senior economist at Mizuho Research Institute.
Shirakawa said the BOJ was responding to a yen rally and a drop in stock prices last week after debt troubles in Dubai briefly threatened to reignite the turmoil of the credit crisis.
The operation may succeed in bringing down some money market rates and commercial paper yields that have stayed high despite the BOJ's other efforts to ease strains that emerged during the crisis. The BOJ scrapped some support for credit markets in October because its facilities had fallen into disuse.
There may also be an impact on the yen which hit a 14-year high against the dollar last week, triggering concern that it could push Japan deeper into deflation.
One effect could be to pull down three-month yen LIBOR compared with dollar LIBOR.
The spread between the respective dollar and yen LIBOR is -4 basis points and has been negative since August, making the U.S. dollar a more attractive funding currency for the carry trade.
The impact may be a small one but it looks enough to help check the yen's rise, said Masayuki Ebira, director at Barclays Bank.
The government appeared to have been placated for now.
The BOJ's action at this time is highly welcome, Hatoyama told reporters.
Ministers said they hoped the measure would bring down long-term interest rates. That would reduce borrowing costs for the most indebted government in any rich nation and lower the risk of recession.
If the BOJ were free from pressure, they wouldn't have done anything, because they've been saying their assessment hasn't changed, said Dariusz Kowalczyk, chief investment strategist at SJS Markets in Hong Kong.
After rebuffing criticism that its view of the economy was too rosy, the central bank had shown signs of caving in and some analysts had expected a return to quantitative easing.
Others had forecast purchases of more government bonds.
But the BOJ stopped well short of both responses. It did not amend the range of collateral against which it would lend the new three-month funds, a move that could channel some cash to smaller companies which the government says are struggling to access credit.
Hatoyama's Democratic Party, which rode to power promising to cut spending on public works so it could offer more support to households, fears another recession in early 2010.
That could hurt the DPJ's chances of winning an outright majority in the upper house to avoid relying on two small, vocal coalition allies to get measures passed unopposed.
(Additional reporting by Stanley White; Writing by Leika Kihara; Editing by Dayan Candappa and Hugh Lawson)