UPDATE2-BOJ vows timely action after forgoing policy move-REFILE

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Tuesday September 07, 2010 02:32:08 PM GMT

(Corrects to add Governor Shirakawa's first name 'Masaaki' in paragraph 2; corrects spelling of 'government' in paragrph 4)

* Policy rate on hold at 0.1 pct, no new steps

* BOJ bracing for possible easing next month

* Gov Shirakawa says always considering various options

* Ruling party leadership race complicates policy outlook (Adds Shirakawa comments)

By Leika Kihara

TOKYO, Sept 7 (Reuters) - The Bank of Japan stood pat on monetary policy on Tuesday but vowed timely action when needed, setting the stage for possible easing next month when it has clarity on Japan's political leadership and the strong yen's damage to the slowing economy.

BOJ Governor Masaaki Shirakawa said he was not ruling out any options. But he offered few clues on what exactly the BOJ may do next and said monetary authorities could not control foreign exchange rates, triggering yen rises on speculation no aggressive action was on the horizon.

Government pressure on the BOJ for more aggressive steps will likely grow in the coming months with the economy expected to slow and as a leadership battle in the ruling party raises the chances of looser fiscal policy, analysts say.

Japanese government bonds have tumbled in the last two weeks, partly due to worries of a possible shift away from Prime Minister Naoto Kan's efforts to rein in Japan's massive public debt if he loses a Sept. 14 vote for the party's top spot to powerbroker Ichiro Ozawa.

Media surveys suggest Ozawa could win and investors are speculating he may be forced to issue more bonds to keep spending promises made when the party swept to power last year, although he maintains the funds can be found by cutting waste and shifting spending priorities.

"So far, the market expectation is that Ozawa would pursue more fiscal expansion than Kan, and the market has to some extent priced in the possibility that Ozawa may become the next prime minister," said Makoto Yamashita, chief Japan interest rate strategist at Deutsche Securities.

"Fiscal expansion can easily be associated with a rise in government pressure on the BOJ to ease. And there are many market players who are looking at it that way."

Others expect the BOJ to come under pressure no matter who wins next week's battle to head the Democratic Party of Japan.

"The BOJ has a tricky political road regardless of who leads the Democrats. Ozawa might pressure the BOJ, but if Kan stays and there's no big fiscal stimulus, this could also pressure the BOJ," said Frederic Neumann, co-head of Asian economics at HSBC in Hong Kong.

SYMBOLIC GESTURE

It is uncertain whether Ozawa is more keen than Kan to pressure the BOJ for further action but a close Ozawa aide told Reuters on Monday that the BOJ was doing too little to fight deflation.

After easing policy just last week, the BOJ kept interest rates on hold at 0.1 percent on Tuesday as widely expected and stuck to its view that the economy was recovering moderately.

But it repeated that it needed to watch out for downside risks to growth amid heightening uncertainty over the U.S. outlook, which has jolted currency and stock markets.

It also warned in a statement on its rate decision that it would take appropriate and timely action when necessary, a point Shirakawa has made in the past.

"We are always considering various policy options," Shirakawa told a news conference. "But monetary authorities are unable to control currency rates freely ... We are carefully watching how the yen's rise impacts the Japanese economy."

The yen climbed against the dollar toward a 15-year high hit last month and surged against the euro following his comments..

Expectations of further monetary easing have pushed down the short end of Japan's bond yield curve, while the long end has been pushed up by speculation that Ozawa, if he wins next week's vote, may take a more fiscal expansionary stance than Kan.

But the yield curve has flattened beyond the 10-year zone lately as investors hunting for bargains trimmed earlier losses in the superlong sector, suggesting that the recent sharp rise in yields may have started to peter out.

Japanese policymakers have tried to talk down the yen and threatened to intervene in the currency market after its surge to a 15-year high against the dollar.

The BOJ also stands ready to ease further if the yen lurches upward at a pace of 1 to 2 percent in a single day. Otherwise, the bank hopes to wait until next month, when it is seen revising down its long-term economic and price forecasts in a semiannual outlook report due on Oct. 28.

The BOJ boosted its cheap loan scheme on Monday of last week, bowing to government pressure for steps to protect the fragile recovery. But the move did little to deter yen gains or stock price falls as investors saw it as a symbolic gesture with little effect in supporting the economy and beating deflation.

That has led some BOJ officials to believe that bolder action is needed to send a clearer message to markets that it is determined to keep the strong yen from harming the economy.

There is no consensus yet on what the next step should be, but the list of options includes a return to zero interest rates and an increase in the bank's government bond purchases.

The BOJ may favour further tweaking its fixed-rate fund supply tool. But its three-month fund supply operation on Monday attracted only 4.37 times more bids than the volume offered, the lowest since the programme was put in place last December, signalling a waning appetite for cheap funds from banks already awash with excess cash. (Editing by Nathan Layne and Edmund Klamann)

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