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 By Leika Kihara and Rie Ishiguro

 TOKYO, Feb 25 (Reuters) - The Bank of Japan remains under
steady government pressure to loosen monetary policy further,
even as the central bank's ammunition to beat deflation dries up.

 While the government has not openly said what exactly it
wants the BOJ to do, it is relying on it to act in the event of a
sharp rise in the yen or in bond yields that could threaten a
fragile economic recovery.

 With the finance minister and others repeating their almost
daily calls for BOJ cooperation to halt falling prices, new signs
of deepening deflation may escalate pressure on the bank.

 Here are some questions and answers on Japan's battle with
deflation and policy options:


 The government does not accept the BOJ's argument that there
is very little it can do with rates already near zero, and
believes it has other options even if they are unconventional.

 For one, the government wants the BOJ to prevent a sharp rise
in the yen because it hurts the export-reliant economy and
accelerates deflation by pushing down import prices.

 That means the BOJ may be pressed to expand the fund-supply
operation it introduced in December shortly after the yen hit a
14-year high against the dollar.

 The finance ministry, in charge of the budget and public debt
financing, also hopes the BOJ will buy more government bonds if
yields surge on worries about Japan's tattered state finances.

 But calming markets will not be enough. Expectations of
stubborn deflation hold back household spending and force
companies to cut prices further, thereby accelerating deflation.

 The government wants the BOJ to change this. It believes that
the BOJ can change public perception that deflation will persist
by resolutely battling deflation through aggressive easing.

 If deflation deepens, the BOJ may come under pressure to
adopt a strict inflation target and make a commitment to achieve
rising prices.

 The government thinks it is doing a great deal to fight
deflation even under fiscal restraint, so it hopes the BOJ will
come up with something to lift inflation expectations as prices
are the BOJ's specialty, a government official said on condition
of anonymity.

 Finance Minister Kan said last week he would favour inflation
of around 1 percent. That roughly matches the BOJ's view, but the
mere mention by Kan of such a goal was a sign the government was
stepping up pressure.



 This is the most likely step. The BOJ could expand the size
of its new fund-supplying operation, at which it lends to banks
at the policy rate of 0.1 percent, from 10 trillion yen ($112
billion) or extend the duration of loans from three months.

 The decision to adopt the new operation in December helped to
lower interbank rates and pushed the yen down from a 14-year high
against the dollar. Further expanding fund supply may push down
the longer end of the curve and offer banks cheaper funding.

 This will not fix deflation unless the money starts flowing
out of the banking system into the economy, which is unlikely
because companies are wary of investment due to the dim economic

 If the yen weakens as a result of the expanded fund supply,
it may help exports and ease deflation through rising import
costs. Any such effect will be short-lived unless the yen
weakness is sustained long enough.


 This would please the government, struggling to balance the
need to support the economy and keep bond issuance in check.

 If bond yields surge on market worries about worsening
finances, and if government pressure heightens, the central bank
may increase bond buying from 21.6 trillion yen per year.

 If the move tames bond yield gains, it will remove one
obstacle to recovery and may help pull Japan out of deflation.
There is no guarantee that yields will react in such a way and
any positive effect may prove short-lived, which is why many BOJ
officials see this as a less favourable option.


 This is highly unlikely. The BOJ believes it already has a
loose target in place. It defines long-term price stability as
consumer price inflation at or below 2 percent, with the
midpoints of most monetary policy board members around 1 percent.

 The bank argues that setting a rigid inflation target, and
committing to doing whatever is needed to achieve it, will bind
its hands in monetary policy and divert attention from factors
such as asset prices.

 Government pressure may force the BOJ to reconsider. The bank
clarified its definition of price stability in December to stress
it will not tolerate zero inflation, let alone deflation, after
the government criticised its economic assessment as too rosy.

 Any target, however, needs to be accompanied by specific
steps for it to succeed in changing market and public
expectations of prolonged deflation, analysts say.
($1=89.57 Yen)
(Editing by Jan Dahinten)