Trying to guess when the Bank of Japan will make its next policy move? For now, try watching the yen.
BOJ sources, talking to media including Reuters, have said in the past week that the board is considering expanding special money market operations, just as the yen strengthened toward a 14-year high against the dollar.
It is probably no coincidence that the yen was headed in exactly the same direction when the BOJ called an emergency meeting in December and pumped funds into the banking system in a move that changed the currency's course.
No one in the BOJ or the government, which is pressing the central bank to do more to fight deflation, has made an explicit link between the policy moves and the foreign exchange market. Instead officials talk of the need to fight deflation.
Any acknowledgment of the link might draw the BOJ and the Ministry of Finance, which controls yen policy, into a battle with the foreign exchange market, requiring them to unleash the ultimate weapon in Tokyo's arsenal -- currency intervention.
The market would likely try to test the will of policymakers if the BOJ admits it is deciding monetary easing steps in relation to the yen's move up, said Tohru Sasaki, chief forex strategist at JPMorgan Chase Bank in Tokyo.
I think BOJ officials know well the danger associated with such an official acknowledgement, said Sasaki, who used to work for an office in charge of intervention operations at the BOJ.
Apart from throwing down the gauntlet to hedge funds and currency speculators, it would also be diplomatically untenable for Japan at a time when the old industrial powers of the G7 are trying to press China to ease its grip on the yuan.
It would be wrong though to accuse Japan of conducting currency market intervention through the back door.
Sasaki likens the BOJ's policy moves to taking a toy gun into a standoff -- the ruse only works if the opponent believes it's real. In many ways the approach says much about impotence of the Japanese policymakers to stem the country's economic decline.
Burdened by debt approaching 200 percent of gross domestic product, the government can hardly go on a borrowing spree to pump-prime the economy.
With interest rates at 0.1 percent, there's little the central bank can do either. The current crop of BOJ policymakers have little faith in quantitative easing, an experimental policy adopted after a 1990s property market crash that barely succeeded in pulling the economy out of deflation.
That leaves the yen.
A strong yen deepens deflation, already the worst on record in a country where prices have been mostly falling for more than a decade.
It also hurts exporters, undermining both Japan's terms of trade and corporate capital investment, the main drivers of economic growth before the global financial crisis triggered the country's worst ever recession in 2008.
The Bank of Japan certainly had its eye on the yen when it called the December emergency meeting as government appeals for a policy response to deflation reached a crescendo.
At the meeting the BOJ decided to pump 10 trillion yen ($110.9 billion) in three-month funds into the banking system, helping push yen LIBOR rate below dollar LIBOR.
That nudged the yen lower against the dollar by making the yen relatively more attractive for funding currency carry trades.
EFFECTS ON CURRENCY
After the emergency meeting, Governor Masaaki Shirakawa said that while the BOJ did not target the foreign exchange market in setting policy, it was aware that news of the move would have certain effects on the currency market in the long run.
The BOJ has also talked of the need to keep funding costs low for corporates by lowering short-term rates. Bank lending fell in February for a third month as smaller businesses refrain from borrowing, raising questions about how effective the policy might be in spurring economic activity.
Still, the BOJ appears to be considering increasing the size of the funding operation or extending the three-month maturity to six months or longer.
While the BOJ and the government have not cited the yen as a concern this time, clouds are gathering in the currency market.
Speculative traders in IMM futures boosted their long yen positions to 35,552 last week -- approaching the two-year peak of 51,710 reached last November as the yen hit 14-year high and just before the BOJ acted.
The yen surged to 84.82 yen to the dollar in late November, the highest since the record peak hit in 1995.
The Japanese currency climbed as high as 88.14 yen last week. A day later Japan's Nikkei business newspaper reported that the BOJ was considering boosting its money supply operations.
There are other signs that the yen is moving up the list of policy priorities.
Last week the government lifted the amount of funds it can borrow to finance foreign exchange intervention.
The 5 trillion yen increase gives it a war chest of 35 trillion yen ($390 billion) in case it needs to overtly stem yen strength by buying dollars and other currencies -- something it has not done in six years.
It may have to resort to that option as the BOJ loses room for maneuver.
The absolute difference in rates is minuscule -- three-month yen LIBOR is now 0.249 percent and less than a basis point below comparable dollar LIBOR. It was 4 basis points above dollar LIBOR in late November.
A further drop in short-term rates would take them near zero and could distort the money market in much the same way quantitative easing did between 2001 and 2006.
These measures would probably exert only a limited and temporary impact on yen appreciation, said Seiji Shiraishi, Japan chief economist at HSBC in Tokyo.
(Editing by Eric Burroughs)