By Leika Kihara

TOKYO, Aug 29 (Reuters) - The Bank of Japan is expected to
hold an emergency meeting early next week to ease monetary policy
as the strong yen threatens the country's fragile economic
recovery, sources familiar with the matter said.

The central bank's board may meet as early as Monday, when
Governor Masaaki Shirakawa is back from his trip to the United
States. If not on Monday, it will likely meet on Tuesday, when
the government is scheduled to outline its measures to stimulate
the economy.

The BOJ's most likely option is to expand a fund-supply
scheme put in place in December under which it offers up to 20
trillion yen ($234 billion) in three-month loans to banks at 0.1
percent, sources familiar with the BOJ's thinking told Reuters.

The central bank has been considering easing policy, but had
initially hoped to wait until its regular rate review on Sept.
6-7 for more evidence of the damage the strong yen was inflicting
on business sentiment.

But the yen's climb to a fresh 15-year high on the dollar
last week and a slide in stock prices have alarmed some in the
BOJ into considering action. The central bank has also been under
increasing government pressure to ease policy.

Prime Minister Naoto Kan said on Friday he hoped to meet
Shirakawa as soon as possible and request a "flexible" monetary
policy response to the strong yen.

The date of the Shirakawa-Kan talks has not been set but the
BOJ would likely try to ease policy before the two meet to avoid
giving markets the impression it yielded to government pressure,
analysts say.

Following are some policy options for the BOJ:

EXPAND FUND SUPPLY TOOL

Possibility: Most likely

The BOJ set up a funding scheme in December that it expanded
in March, which offered up to 20 trillion yen in three-month
loans at 0.1 percent. The decision to set up the scheme was made
at an emergency meeting held a day before Shirakawa met with
then-Prime Minister Yukio Hatoyama.

That failed to boost bank lending, which marked its eighth
straight month of annual falls in July. But it helped to push the
yen further away from a November high.

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

Sceptics at the BOJ argue that the yen's drivers are
different now than they were in December. Investors now view the
yen more as a safe haven and are not focusing on short-term
interest rate differentials like they were in December.
Therefore, lowering money market rates this time might not have
the impact it had in 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.

Still, it is among the favoured options within the BOJ as it
is easier to implement than other more aggressive measures.

The move would be more of a token gesture to show the central
bank was doing what it could to support the economy.

Market reaction: It would have little impact on money market
rates and the yen, as such a move is already widely expected in
the markets.

BUY MORE GOVERNMENT BONDS, ASSETS

Possibility: Less Likely

This is a less attractive option for the BOJ, which worries
that increasing government bond purchases from current levels of
21.6 trillion yen per year could give the impression it was
directly financing government spending.

But it would surprise markets and please the government,
which may not be satisfied with the widely expected move of
expanding the BOJ's fund supply scheme.

Although 10-year bond yields have already dipped below 1.0
percent, buying more bonds could be a more effective way to
support growth as long-term yields still have room to fall.

Additional buying could also weaken the yen by showing
markets its determination to expand fund supply, analysts say.

Market reaction: Bond yields might briefly fall, subsequently
pushing down the yen. But there could be a danger of yields
rising if markets felt Japan was losing control over its debt.

STRENGTHEN COMMITMENT TO EASY POLICY

Possibility: Unlikely

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

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

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

The challenge would be to 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, might fall. But the move could be short-lived as
such a 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 did during its
five-year quantitative easing policy until 2006. It now targets
interest rates, whereas under its quantitative easing policy it
targeted liquidity.

But it is strongly against reverting to a formal quantitative
easing policy with a 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 they were a decade ago, 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 favoured options, as it would discourage banks
from trading in the money market and make it hard for the BOJ to
guide short-term rates.

But the BOJ may opt to set a range of zero to 0.1 percent as
its new policy target if it feels expanding its fund supply tool
could push down overnight rates well below 0.1 percent.

Market reaction: The shift would come as a surprise and
sharply push down money market rates, bond yields and the yen.

(Editing by Nathan Layne)