BOJ may hold fire until next year as election looms

By Leika Kihara

TOKYO (Reuters) - The Bank of Japan is set to hold fire next week and may also defy market expectations of action in December, pushing back any further monetary stimulus until early next year to size up the policies of a new government, sources say.

That scenario is based on expectations that the Japanese economy will go through a shallow recession, and those familiar with the central bank's thinking say it still stands ready to act if the economy takes a sharp turn for the worse.

Markets expect the central bank to come under more pressure for action given that polls suggest opposition leader Shinzo Abe will become the next prime minister after next month's elections. Abe wants the BOJ to supply unlimited amounts of cash to spur the economy and achieve 3 percent inflation.

Feeling the heat, central bankers have been weighing options beyond the current asset-buying program such as targeting riskier assets, buying bonds more aggressively or setting a higher inflation target.

Their preferred approach is to save these options for as long as possible until there is clarity on whether Abe indeed will take the helm and if so, whether he would stick to his demands for extreme measures like unlimited money printing.

"The BOJ's focus has been on what to do next year. The key is who would become finance and economic ministers," said one of the sources familiar with central bank's thinking.

Another source expressed a similar view. Both spoke on condition of anonymity due to the sensitivity of the matter.

Prime Minister Yoshihiko Noda is set to dissolve the lower house of parliament on Friday for a snap election on December 16. The new government's cabinet line-up and policy stance may not be clear until January, depending on the outcome of the vote.

SHAKY GROUND

The BOJ eased monetary policy in October for the second time in as many months. Governor Masaaki Shirakawa has signaled the central bank has done enough for now, saying on Monday that flooding markets with cash alone won't nudge up prices.

The wait-and-see strategy rests on the assumption that the economy is going through a soft patch and will start picking up sometime in the first half of next year.

Economic output fell 0.9 percent in the quarter to September and analysts see another contraction in the final three months of this year, as slowing global growth and the pain from a territorial row with China hit exports and factory output.

The BOJ may cut its assessment of the economy at its November 19-20 meeting as private consumption and capital spending, which had made up for some of the weakness in exports, lose momentum.

Some pessimists on the board may thus call for action in December, if not this month, particularly with the BOJ's quarterly "tankan" survey due out next month set to show a sharp deterioration in business sentiment and capital spending.

Any further signs that the current stagnation could turn out more severe or prolonged than in the BOJ's base scenario would put the pressure on the bank to act at its December 19-20 meeting.

Many market players are already factoring in further easing at the December meeting, which will be held three days after the Japanese election and a week after the U.S. Federal Reserve's rate review.

"The BOJ has run out of measures that would have any immediate effect in reviving growth. But it may act in December if the Fed pledges bigger stimulus," said Yasuo Yamamoto, senior economist at Mizuho Research Institute in Tokyo.

With interest rates effectively at zero, the BOJ put in place in 2010 as its key monetary easing tool a pool of funds to buy assets ranging from government bonds to corporate debt.

It set a 1 percent inflation target in February and expanded the asset-buying program four times this year, now pledging to pump 91 trillion yen ($1 trillion) by the end of next year.

But it has been under constant pressure from the ruling Democrats and the opposition to act more aggressively to beat deflation.

Abe, who leads the biggest opposition Liberal Democratic Party tipped to win the next polls, has been particularly vocal in demanding that the BOJ set a more ambitious inflation target and pull out all the stops to achieve it.