Japan's prime minister said on Friday he will take firm measures on currencies when needed and will meet the Bank of Japan governor, increasing the possibility the central bank will ease policy soon as it confronts a surging yen.
The yen edged lower after Kan's remarks as Japanese policymakers struggle over how to put a cap on the currency, which hit a 15-year high against the dollar this week and threatens to derail an export-led recovery.
The ruling Democratic Party's options on fiscal policy are limited due to the country's large debt burden, so it is leaning on the central bank to ease policy to help the economy.
There are investors who are expecting the Japanese authorities to take some measures if the yen appreciates sharply, said Mitsuru Sahara, chief manager for currency derivatives trading at Bank of Tokyo-Mitsubishi UFJ.
It's possible that the government's stimulus steps and the BOJ's easing measures will be announced together, even before its next meeting, he said, referring to the central bank's rate review on September 6-7.
There's a growing view that Japan could even conduct solo intervention if the yen rises sharply.
BOJ Governor Masaaki Shirakawa is scheduled to attend the Federal Reserve's seminar in Jackson Hole, Wyoming, until August 30, and Kan said he would meet Shirakawa after he returns to Japan.
Kan said the government would outline measures on August 31 to support the economy and grapple with the strong yen.
Excessive currency moves can harm the economy and the financial system, he told reporters after visiting a small factory in the Tokyo suburbs. We will take firm measures when needed.
The fate of any economic package could be complicated, however, by a ruling Democratic Party leadership vote on September 14, in which party powerbroker Ichiro Ozawa is challenging Kan.
The dollar rose slightly to 84.82 yen after Kan's comments, near its high for the session, but remained below the closely watched 85 mark and not far from a 15-year low of 83.58 yen hit on trading platform EBS earlier this week.
Sources say the BOJ is considering easing policy further at its upcoming rate review, or even before that, but it is expected to opt for only a minor tweak of its funding framework instead of bolder steps such as increasing its government bond purchases.
Analysts say such a modest step would do little to slow the yen's rise or bolster the fragile economy.
Debt markets are already pricing in the chance of a BOJ easing. With short-term rates already very low, investors are pushing down the longer end of the curve, although the yield curve steepened on Friday as banks sold super-long bonds to take profits.
The BOJ is hesitant to return to full-blown quantitative easing since the policy, which involves flooding markets with extra cash under a liquidity target, had little effect in beating deflation when it was in place until March 2006.
Japan has not intervened in the currency market since March 2004, when it ended a 15-month 35 trillion yen (266.5 billion pound) selling spree aimed at rescuing an economic recovery.
The firmer yen also threatens to delay Japan's exit from deflation, putting further pressure on the central bank to act.
Japan's core consumer price index (CPI), which includes oil products but excludes fresh food prices, fell 1.1 percent in July from a year earlier, data from the internal affairs ministry showed on Friday, matching the median market forecast. It was slightly bigger than a 1.0 percent drop in June.
The core-core inflation index, which excludes food and energy prices and is similar to the core index used in the United States, fell 1.5 percent in July from a year earlier.
Given the yen's gains, exports will slump temporarily and slow Japan's economic recovery. Japan will thus remain in deflation for another two to three years, said Takeshi Minami, chief economist at Norinchukin Research Institute.
The BOJ may expand its fund-supply tool next month, but the effect on short-term interest rates will be limited. It needs to take bolder steps to beat deflation and the strong yen, such as increasing outright government bond purchases, although that's unlikely to happen soon.
The BOJ has justified holding off on aggressive measures to beat deflation with its forecast that consumer prices will turn positive in the fiscal year ending in March 2012.
The government steps due at the end of the month are likely to delay the end of subsidies on purchases of energy-efficient electronics.
But any positive effect on the economy will be limited as spending under the stimulus plan will be small and any measures taken by the BOJ will be minor and cosmetic, analysts say.
(Writing by Leika Kihara; Editing by Edmund Klamann & Kim Coghill)