The Bank of Japan will ease monetary policy this week and consider adopting a 2 percent inflation target no later than in January, sources say, responding to pressure from next Prime Minister Shinzo Abe for stronger efforts to beat deflation.
Turning up the heat, Abe made a rare, direct push for a higher inflation target when BOJ Governor Masaaki Shirakawa visited the headquarters of his Liberal Democratic Party (LDP) on Tuesday.
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"I told him that during my election campaign, I called for setting a policy accord with the BOJ and a 2 percent inflation target," Abe told reporters. "The governor just listened," he said when asked how Shirakawa responded.
The LDP swept to power in Sunday's lower house election after campaigning for big fiscal spending to revive the economy and "unlimited" monetary easing to achieve higher inflation in a country mired in deflation for the past 15 years.
A day after the election, Abe called on the BOJ to boost its monetary stimulus at a two-day meeting that ends on Thursday and pressed it to adopt a 2 percent inflation target, double its current price goal, as soon as next month.
Under pressure, the central bank will likely ease policy this week amid looming risks to Japan's economic outlook, sources familiar with its thinking have told Reuters, and may also start debating how to meet Abe's calls to set a higher price target.
Abe will form a new cabinet on December 26 and is seen choosing Taro Aso as finance minister, Japanese media said, a former prime minister expected to toe the party's line calling for aggressive easing and public works splurge.
That means the central bank will be under pressure to respond again at its policy-setting meeting on January 21-22, when it is set to cut its economic forecast for the year ending in March 2013 due to the widening pain from slowing global growth.
"Abe's comments have really raised expectations for easing this week," said Norio Miyagawa, senior economist at Mizuho Securities Research & Consulting in Tokyo.
"I think the BOJ will deliver with increased purchases of government debt. Next year could also be a big year for monetary policy easing, because of the inflation target debate and a change in leadership at the BOJ."
Fourteen of 19 economists polled by Reuters last week said they expected the BOJ to ease this week, most likely by increasing its 91 trillion yen ($1 trillion) asset buying and lending program by up to 10 trillion yen.
The BOJ currently has a 1 percent inflation target but has said this is a goal for the time being, and that it considers a range of zero to 2 percent as long-term desirable price growth.
The central bank may thus opt to clarify that after the 1 percent inflation is met, it will aim for 2 percent inflation as a long-term policy goal, to meet demands from Abe for more aggressive monetary stimulus.
The BOJ and the government may issue a joint statement, similar to one crafted in October between the central bank and the outgoing government led by the Democratic Party, pledging to take measures to aim for 2 percent inflation in the long run, the sources said.
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Shirakawa told reporters he did not discuss monetary policy with Abe, and that he only visited to pay respect. It is rare for a premier or a would-be prime minister to reveal what was discussed at a closed-door meeting with a central bank governor.
The BOJ has eased monetary policy four times so far this year via an increase in its asset-buying and lending program. But politicians like Abe have criticized the central bank for not doing enough to end 15 years of grinding deflation in Japan.
Some central bankers are keen to boost stimulus again, with the world's third-largest economy already in mild recession and unlikely to rebound strongly early next year due to weak exports to China and the potential impact from the U.S. "fiscal cliff."
Any BOJ action on Thursday will likely take the form of a further increase in its asset-buying program. But central bankers, feeling the heat, have been privately pondering options for next year including setting a higher inflation target and buying government bonds more aggressively.
Through such steps, they hope to stave off threats by Abe of revising the BOJ law guaranteeing its independence.
But there is strong resistance within the BOJ on setting a 2 percent inflation target in a country that has barely seen price growth exceed 1 percent in the past two decades. Japan's core consumer inflation was flat in October from a year earlier after five straight months of declines.
BOJ officials close to the conservative Shirakawa are wary of setting a higher price target without having effective means of achieving it. They also fret that pumping too much money into the economy could brew seeds of imbalances, such as sharp rises in asset prices, in the long-term.
But Abe, whose LDP and its small ally New Komeito captured a two-thirds majority in Sunday's landslide victory, has swiftly moved to press his agenda.
On Tuesday, Abe told reporters that he had agreed in a telephone call with U.S. President Barack Obama that the two would try to meet next month, part of a push to strengthen ties with Washington and give Japan a greater global security role.
The choice of Aso, 72, as finance minister suggests Abe is looking to experienced LDP lawmakers to fill key posts to avoid criticism that his ministers lack experience.
While Aso's views on monetary policy are little known, as prime minister he launched massive stimulus packages to combat the global financial crisis in 2008.
The new finance minister, along with the economics minister, can attend or send subordinates to BOJ policy-setting meetings. They cannot vote on policy decisions but can voice opinions and request a delay in a vote.
($1 = 83.7600 Japanese yen)
(Writing by Leika Kihara, additional reporting by Yoshifumi Takemoto, Sumio Ito and Kiyoshi Takenaka; Editing by Raju Gopalakrishnan)