It was a secret Valentine's Day mission involving only half a dozen Bank of Japan bureaucrats who worked through the weekend preparing for the central bank's February 13-14 meeting.

The governor had just been publicly heckled by politicians over seemingly endless deflation and a yen near record highs. Bold steps were needed to restore the BOJ's standing, and quickly.

Until February, the BOJ's message was that mild deflation was inevitable, and that it didn't need to act as long as the economy was doing fine, said a source familiar with the central bank's thinking. That perception had to change.

The inner core working that weekend at the BOJ knew surprise would be the key to success, and so abstained from the usual practice of leaking plans to the media to massage expectations.

It worked a treat. Unsuspecting markets were stunned by the BOJ's two-punch combination of adopting a 1 percent inflation target and a hefty increase in its bond buying.

The yen was knocked down just as effectively as if the BOJ had bought hundreds of billions of dollars in currency intervention, and over the next month fell to an 11-month low.

Perhaps more importantly, the Valentine's Day surprise marked a fundamental change in the way the central bank sees its mission, how it will carry it out and sell it to the public.

The central bankers had been aware for some time of two problems. First, with interest rates already near zero and the economy mired in deflation, their conventional tools were not working. Second, the BOJ had an image problem, perceived as an institution always doing too little too late.

So the BOJ very deliberately sent investors and politicians the signal they have been waiting for -- that it was ready to deploy unconventional weaponry to lead Japan out of deflation.

When you set a goal, you have to show that you're serious about achieving it. You have to meet words with action, said a senior official at the central bank.

The remaking of the central bank is only beginning. Over the next year there will be new board members and possibly a new governor - a chance to shape thinking on how to reinvigorate the world's third-largest economy.

The challenge for all will be how to reconcile calls for vigorous action to take Japan to its inflation goal - a level it has not seen for nearly two decades save for a few blips - and concerns it could be seen as bankrolling vast government debt.


Graphic on BOJ move yen, yield impact

Graphic on CPI, overnight call rate

Graphic on BOJ, Fed balance sheets



The plan to shake up monetary policy started to take shape in December, sources close the central bank said.

There was push to act in January when the yen was near record highs and the risk of a disorderly Greek default loomed large, and most in the nine-member policy board were leaning toward action.

But it would take another month to convince Governor Masaaki Shirakawa, who remains skeptical of what can be achieved by pumping cheap money into an economy beset by structural problems like an ageing population and shrinking workforce.

Those who have worked with him say he is particularly uncomfortable doing something just for psychological effect, and in his view that includes feeding more cash to banks that have trouble absorbing the funds already available to them.

Central banks normally worry about containing inflation, but Japan has been faced with persistent falls in prices. Deflation weakens the economy because it encourages consumers and businesses to hold off on spending because prices will fall, and companies struggle to pass on higher costs of fuel and commodity imports.

Insiders say hostile grilling of Shirakawa in parliamentary hearings the week before the February meeting may have persuaded the soft-spoken career central banker to move.

Lawmakers demanded the BOJ set a clear inflation goal the way the Federal Reserve had, repeatedly heckling the 62-year old banker. At one point the jeers got so loud that they drowned Shirakawa's voice, and it was all broadcast live on television.

People who watched that scene would have thought the BOJ wasn't doing anything to cure Japan's ills. That image had to be changed, said a source with knowledge of the BOJ's thinking.


Tired of being a whipping boy for politicians who have long shied away from fiscal reform, central bankers decided to wrest back the initiative and also show some support to Prime Minister Yoshihiko Noda, whom they view as best placed to put Japan's tattered finances back in order.

With public debt at twice the size of the $5 trillion economy, Noda's plan to double the sales tax to 10 percent is under attack from those who say the economy is still too weak.

With even members of his own party opposed to the plan, Noda needs all the help he can get and sources say the central bank is ready to provide that to some extent.

The sources say that in contrast to past spells of tense relations between government and central bank chiefs, Noda and Shirakawa get along well and meet about once every three months casually, sometimes over breakfast or lunch.

There is now trust and a good working relationship between the two sides, said a source with knowledge of the meetings.

But while relations between the finance ministry and central bank have been less fraught since February, bureaucrats at the ministry are still seeking further stimulus from the BOJ to keep the economy strong enough to weather any future sales tax hike, say officials with direct knowledge of the negotiations.


With Shirakawa at the helm, there will be tension between those in the BOJ keen to sustain the psychological effect of the central bank's new image of a bold deflation fighter, and his supporters who are wary of using heavy monetary artillery too often.

He doesn't like 'big bang' steps. It's not his style, said a former BOJ board member who worked with Shirakawa.

Indeed, the central bank has found itself playing down the impact of its February move to temper expectations of further bombshell steps.

The board meets again next week, although markets expect that any follow-up action to the February meeting will be delayed until a late April meeting that includes a review of macroeconomic forecasts.

Many who have worked with Shirakawa say the hard-working perfectionist is cautious by nature and has a stubborn streak, although the February moves show he is not an obstructionist.

His term as governor ends in April 2013. Theoretically Shirakawa could be reappointed, but the government is likely to look for someone willing to step outside the boundaries of traditional central banking.

Toshiro Muto, a former finance ministry bureaucrat and deputy BOJ governor who is considered a leading candidate to succeed Shirakawa, says the central bank is already pursuing quantitative easing, where the stimulus is measured by liquidity released into the financial system rather than the level of official rates, even if it is not explicitly using the term.

One step Shirakawa has been reluctant to make and which Muto said could be necessary was to buy more longer-dated government bonds to prolong the stimulative effect.

Whatever it does might have to be small steps. But the BOJ's next challenge is to come up with ways to further pursue its quantitative easing policy, Muto told Reuters in an interview on March 30.


Shaping Shirakawa's caution is his experience in 2001-2006 as one of the elite BOJ bureaucrats who masterminded the central bank's previous spell of quantitative easing, where it targeted cash balances of commercial banks.

Shirakawa believes the cash was not funneled to productive sectors and did not prevent Japan from slipping into a decade of economic stagnation and grinding deflation.

Having joined the BOJ in 1972, he has spent most of his career facing the traditional problem of containing inflation as Japan's economy boomed and asset price bubbles grew, whereas views of his younger cohorts have been shaped by economic stagnation and deflation.

So while many BOJ bureaucrats agree that merely flooding the economy with funds may not provide the spur to end deflation, they are also not as concerned about the risk of asset price bubbles re-emerging or inflation getting out of control.

And they worry that years of brow-beating by politicians have eroded confidence in their institution and baby steps are not enough to restore it.

Markets got the impression the BOJ changed in February and that's reasonable. It changed in the sense it is starting to violate a rule it made for itself, said Teizo Taya, a former board member who left the BOJ in 2004 and is now a professor of economics at Tokyo's Rikkyo University.

A test for the new mindset will be what the BOJ does on quantitative easing over coming months.

Under its asset buying scheme the BOJ only buys government bonds of up to two years until maturity. But with two-year yields already at 0.1 percent, any further increase in the scheme would have to target five-year bonds to be effective.

That would blur the distinction between the asset-buying scheme, intended to be a temporary stimulus, and another operation where it buys 21.6 trillion yen ($263 billion) in long-term bonds per year.

Buying more bonds would bring it closer to violating a self-imposed rule that its government bond holdings should not exceed the value of banknotes in circulation.

Muto says the central bank should not worry about its rules too much if circumstances call for action.

If the BOJ, out of necessity to prevent a plunge in bond prices, needs to buy bonds beyond what's accepted under the banknote rule for a certain period, it should do so, he said.

The February action turned out as a surprise. The BOJ did more than what was expected. On the other hand, there is room to do more. The real test has only just begun.

($1 = 82.20 Japanese yen)

(The story was refiled to add dropped word in 3rd paragraph below the last heading)

(Additional reporting by Rie Ishiguro; Editing by Tomasz Janowski and John Mair)