Japanese cabinet ministers piled yet more pressure on the Bank of Japan on Tuesday to respond to deflation, with one saying the central bank was asleep at the wheel.
The government last week declared that Japan had entered its second bout of deflation in less than a decade, as a public battle brews between the administration and the BOJ over how to manage the economy.
Each says the other should play a greater role in battling deflation, which is forecast to dog the economy for several years, raising fears of another recession.
Prime Minister Yukio Hatoyama's government is only two months old and is largely untested in fiscal policy. But it has adopted the kind of heavy-handed approach towards the BOJ that previous governments have used to influence monetary policy.
The Democratic Party-led government has criticised the BOJ for having too rosy a view on the economic outlook and banking minister Shizuka Kamei, a strident critic of the BOJ, kept up the attack.
The situation is serious, Kamei, leader of a small political party in the governing coalition, said on Tuesday.
The Bank of Japan is asleep at the wheel as usual, he told reporters after a cabinet meeting. Because the BOJ is independent, we can't simply lash out and wake it up. In that context, the government's role is very important.
The government has been vague on what it wants from the BOJ beyond keeping rates near zero, but analysts say the most likely option is for the central bank to increase its government bond purchases to cap any rises in long-term yields.
The new government is shifting spending to welfare from infrastructure, but that will take time to have an impact, said Simon Wong, a regional economist at Standard Chartered in Hong Kong.
At some point the BOJ will have to increase its purchases of Japanese government bonds, because if you have deflation on one hand and rising yields on the other, you will have rising real interest rates and that will hurt the recovery.
The government is burdened by the highest public debt burden among industrialised countries at about 170 percent of gross domestic product, leaving it little leeway to splash out on stimulus to keep the economy growing.
Finance Minister Hirohisa Fujii said fiscal policy cannot be the main tool to make up for Japan's lack of demand.
Monetary policy is principally responsible for price trends, he told reporters on Tuesday.
The BOJ may face pressure to increase its purchases of government debt -- pumping more cash into the economy -- although economists say that may not do much to close a large gap between supply and demand that is weighing on consumer prices.
Two government representatives, one from the Cabinet Office and another from the finance ministry, attend BOJ policy meetings. They cannot vote but can request delays in votes.
QUANTITATIVE EASING AGAIN?
The BOJ on Friday upgraded its assessment of Japan's economy despite grumblings from the government, which on the same day declared the economy was in mild deflation.
In the hope of defusing tension with the government, the BOJ renewed its pledge to maintain very easy monetary conditions by keeping its interest rates at 0.1 percent.
Central bank Governor Masaaki Shirakawa said on Friday that falling demand was the root cause of deflation, suggesting that fiscal spending must also play a role.
The BOJ has defied the government in the past, demonstrating its independence by ending zero interest rates in August 2000. That decision proved premature and forced the BOJ into an embarrassing climbdown.
Less than a year later the BOJ abandoned its rate target and began flooding the financial system with cash under a form of quantitative easing, after the government declared the economy was in mild deflation.
In October, the BOJ did bow to government pressure by deferring a widely expected decision on withdrawing support for corporate finance.
The BOJ is unlikely to revert to its narrow definition of quantitative easing, in which it set targets for commercial bank reserves held at the BOJ.
But it could implement quantitative easing in a broader sense by buying more JGBs as investors fret that long-term yields could rise next year due to increased government borrowing, analysts say.
The government is likely to ask the BOJ to ease policy further in the second quarter of next year, and the most likely response is for the BOJ to buy more JGBs and offer some measures to support corporate finance, said Yasuo Yamamoto, a senior economist at Mizuho Research Institute.
The government's ambitious spending agenda prompted ministries to request a record 95 trillion yen ($1.1 trillion) for the budget for the fiscal year starting in April, fanning fears the government will need to sell a record amount of bonds to fund its policies.
The BOJ buys 21.6 trillion yen of JGBs each year and has been reluctant to increase purchases, arguing that its government debt holdings are already approaching its self-imposed ceiling.
Consumer price deflation probably moderated only slightly in October as weak domestic consumer demand offset the waning impact of a slide in oil prices, data on Friday is forecast to show.
The BOJ is already forecasting three years of deflation, and economists warn that because domestic demand is weak, deflation will likely persist.
The government nominates candidates for BOJ governor, who must be approved by both houses of parliament. The Democrats, while in the opposition, accepted Shirakawa's nomination last year after opposing several candidates, saying they could not ensure the bank's independence. ($1=89.03 Yen)