Bank of Japan Deputy Governor Hirohide Yamaguchi said the central bank was ready to act to beat deflation, leaving room for more monetary easing amid a steady drumbeat of government pressure for BOJ steps to support the economy.
But Yamaguchi, a career central banker seen as close to the governor, offered few clues on what exactly the Bank of Japan might do beyond keeping interest rates near zero.
While Japan struggles with weak domestic demand, which Yamaguchi described it as the root of the deflation problem, exports have been rebounding.
Exports marked their third-biggest annual gain on record in January due to rising chip and auto shipments, trade data showed, allaying concerns that China's moves to rein in lending may choke off demand there and put a brake on Japan's economic recovery.
Still, this positive sign is unlikely to stop the government from pushing the BOJ to combat deflation as Prime Minister Yukio Hatoyama's cabinet eyes an upper house election expected in July.
The BOJ can't escape the fact that prices are still declining, said David Cohen, director of Asian economic forecasting at Action Economics in Singapore.
The BOJ would be happy to stay on hold indefinitely, but they could do something to lower short-term rates to appease the government. Price declines will narrow as long as the global economy continues to recover -- but a decline is a decline.
Yamaguchi said the BOJ's key task was to boost demand and show its determination to beat deflation so the public doesn't start to think price falls will persist and hold off on spending.
It's important to make sure corporate sentiment doesn't shrink, so that deflation doesn't trigger economic weakness and further aggravate deflation, he said in a speech to business leaders in Kagoshima, southern Japan, on Wednesday.
If deemed necessary given economic and price conditions and changes in financial conditions, the BOJ is always prepared to implement appropriate measures at the appropriate time.
The government, weighed down by a huge fiscal debt, has been urging the BOJ to support the fragile economy even as most other major central banks mull rolling back stimulus steps put in place during the global crisis.
Many analysts say the BOJ could pump more money into the banking system or offer cheap longer-term funds to bring down longer-dated interest rates such as six-month rates, particularly if the yen rises further and threatens to deepen deflation.
Government pressure for further monetary easing is still there and may increase if the yen jumps or stock prices fall toward the fiscal year-end in March, said Izuru Kato, chief economist at Totan Research in Tokyo.
The BOJ is probably considering how it should respond when government pressure increases.
Japan's yield curve has steepened as expectations the BOJ could ease monetary policy again has kept shorter-dated yields low, while longer-dated maturities have suffered from concern about Japan's fiscal debt, which is nearly twice the size of the economy.
In a subtle warning to the government, Yamaguchi said that while markets have smoothly absorbed the huge amount of public debt so far, the country's fiscal state was in a severe state.
Long-term rates as well as other markets are always focusing on how the government deals with (Japan's fiscal problem), he told a news conference.
A rebound in exports has been a major driving force behind Japan's recovery since the second quarter of 2009, with shipments to Asia leading the way thanks to strong growth in the region. Asia accounts for more than half of Japan's exports.
Exports to China, the destination for 19 percent of Japan's shipments abroad, logged their biggest annual rise since August 1985, while those to the United States rose for the first time in nearly two and a half years on an annual basis, Ministry of Finance data showed.
Compared to the previous month, Japan's exports rose for the 11th consecutive month in January.
For a graphic of Japan's exports by destination, click:
Steelmakers like Nippon Steel Corp and JFE Holdings Inc have increased their exposure to Asian markets as demand at home stagnates. Revenues from overseas markets now account for nearly half of their overall sales.
But strong Asian growth may in fact delay Japan's exit from deflation as it lures more local firms offshore, depriving the country of new jobs and investment.
Deflation hurts the economy as households put off spending on hopes that prices will fall further, forcing companies to cut prices to lure consumers.
Data due Friday will likely show the core consumer price index fell 1.4 percent in January from the previous year, with annual price falls accelerating for the first time since they slumped by a record in August.
(Additional reporting by Rie Ishiguro, Stanley White; Editing by Hugh Lawson)