July 30, 2010 –   By Leika Kihara

TOKYO, July 30 (Reuters) - The Bank of Japan is expected to opt for minor tweaks if it were to ease policy further, avoiding radical steps such as a return to quantitative easing.

The central bank sees no point in force-feeding money to banks, which have abundant cash but little use for it because uncertain economic outlook makes firms reluctant to borrow.

With the economy recovering, the BOJ does not see an immediate need to ease its policy further and its near-term focus is to shield the economy from adverse market moves, such as sharp yen gains that could hurt exports and business sentiment.

It stands ready, however, to act if economic conditions deteriorated and below are some of its policy options:

EXPAND FUND SUPPLY TOOL

Possibility: Most likely

The BOJ started in December, and expanded in March, a fund supply scheme under which it funnels up to 20 trillion yen ($230.5 billion) in three-month loans to banks at 0.1 percent.

It failed to boost bank lending, which marked its seventh straight month of annual falls in June, but helped push the yen off a 14-year high against the dollar in December.

Increasing the amount of funds available, or extending the duration of loans to six months, may push down interbank lending rates and indirectly weaken the yen, analysts say.

The BOJ does not rule out such an option, but sceptics there argue that with investors now viewing yen more as a safe haven than focusing on short-term interest rate differentials, lowering money market rates will not stem yen rises the way it did last December.

"It's an option but it won't work both in terms of affecting currency moves and supporting the economy," said a source familiar with the BOJ's thinking. The move would therefore be a token gesture to show the central bank was doing what it could to support the economy.

In December, the scheme's launch pushed three-month yen LIBOR rates below dollar LIBOR, nudging the yen lower against the dollar by making it relatively more attractive as a carry trade funding currency. Now yen LIBOR rates are already below dollar LIBOR.

Market reaction: It may push down longer-term money market rates, such as six-month yen borrowing costs.

BUY MORE GOVERNMENT BONDS

Possibility: Likely

A less attractive option for the BOJ, worried that increasing its bond purchases from the current 21.6 trillion yen per year may give markets the impression it is directly financing government spending.

But this may become tempting if benchmark 10-year bond yields, now hovering at a seven-year low, bounce back on renewed worries about Japan's tattered finances. By buying more bonds the central bank would ease the pressure on the government. It could also prove a more effective way of propping up the economy, affecting longer-term yields, which have more room to fall than short-term rates that are close to zero.

Market reaction: Bond yields may briefly fall, subsequently pushing down the yen. But yields may bounce up if markets feel Japan is losing control over debt management.

STRENGHTEN COMMITMENT TO EASY POLICY

Possibility: Less likely

If the government steps up pressure on the BOJ to ease its policy further it may cave in to lawmakers' calls to set a more rigid inflation target and commit itself to more steps to beat deflation.

But this is highly unlikely for now, as Governor Masaaki Shirakawa is against setting a strict price target for fear of binding future monetary policy, BOJ officials say.

It may instead opt for a more vague commitment, such as pledging to keep rates low until Japan is comfortably out of deflation. The Federal Reserve's stated commitment to keep official rates low for an "extended period" could be a good example, analysts say.

The challenge would be make the pledge clear enough to be effective, but vague enough to leave policy options open.

Market reaction: Two-year bond yields, most sensitive to monetary policy, may fall. But the move may be short-lived as such commitment is effective when markets are starting to factor in the chance of a rate hike, which is not the case now.

REVERT TO QUANTITATIVE EASING, ZERO RATES

Possibility: Highly unlikely

The BOJ already floods markets with cash as it had done during its five-year quantitative easing policy until 2006.

But it is strongly against reverting to a formal quantitative easing policy with its liquidity target, as it feels the policy did little to boost the economy or beat deflation.

Achieving a liquidity target would also be tougher now as banks are in less need of funds than early this decade, when Japan was mired in a severe credit crunch, BOJ officials say.

Cutting the policy rate to zero from 0.1 percent is also among the least favourable options, as it would discourage banks from trading in the money market and make it tough for the BOJ to guide short-term rates.

Market reaction: The shift would come as a surprise and sharply push down money market rates, bond yields and the yen. (Editing by Tomasz Janowski)