* Dollar/yen retreats after hitting high of Y90.25
* Traders winding back yen selling ahead of BOJ decisions
* Markets position for aggressive action from BOJ
* Sterling hurt by weak British retail sales data
By Hideyuki Sano
TOKYO, Jan 21 The yen hit a 2-1/2 year low against the dollar before quickly bouncing back on Monday as traders braced for the outcome of a Bank of Japan meeting that is expected see the central bank commit to an aggressive reflationary policy.
Under political pressure to pull the country out of deflation, the BOJ is expected to unveil a raft of policy steps including further quantitative easing and setting a 2 percent inflation target at its two-day meeting that ends on Tuesday.
The dollar rose to as high as 90.25 yen earlier on Monday, the greenback's highest level against the Japanese currency since June 2010, but had steadied to 89.53 yen by 0545 GMT.
But as traders rushed to lock in gains as a precautionary step before the BOJ's policy meeting ends, the dollar slipped to 89.60 yen, down 0.6 percent from late U.S. trade on Friday.
Since mid-November, the dollar has risen about 13 percent on the yen.
"From here we will probably see rallies sold into in euro/yen, Aussie/yen etcetera as the street reduces short yen positions into the BOJ meeting tomorrow," said Jeffrey Halley, FX trader for Saxo Capital Markets in Singapore.
The euro traded at 119.39 yen, off a 20-month peak of 120.73 hit last week while the Australian dollar shed 0.5 percent to 94.19 yen, slipping from a four-year high of 95.02 set Friday.
Minori Uchida, chief currency analyst at the Bank of Tokyo-Mitsubishi UFJ, said the market had almost fully factored expectations for BOJ easing, unless the central bank sprang a surprise on Tuesday.
"The dollar could rise to as high as 91 yen, but it will eventually return to 80-85 yen," he added.
Market expectations on the BOJ meeting are unusually high. Traders say financial markets are expecting a joint statement with the government to target two percent inflation, an increase in asset purchases with an open-ended commitment, and possibly other measures such as cutting interest rates on excess reserves.
Data last Friday showed currency speculators slightly trimmed their bets against the yen in the week to Jan. 15, although they remained overwhelmingly negative on the currency.
Many market players remain pessimistic on the yen.
"We expect the door for further easing will likely be left open irrespective of the outcome of BOJ policy meeting, either explicitly by the BOJ or implicitly through government's plan to nominate doves to replace the governor and deputy governors," analysts at Barclays Capital wrote in a client note dated Jan. 20.
"Expectations of an aggressive monetary policy stance under new BOJ leadership are likely to provide support for USD/JPY in coming weeks."
Traders said there has been strong demand for options betting on further yen weakness, with one-month dollar/yen implied volatility - a measure of expected price movement - having risen to its highest since August 2011 on Friday.
The euro stood flat at $1.3325, having been capped by the $1.3400 level in the past week and facing strong resistance just under $1.3500.
The single currency showed muted response to a victory of Germany's centre-left opposition in a regional vote in Lower Saxony on Sunday. The euro crisis did not play much of a role in the vote.
Sterling touched a two-month low near $1.5840, remaining under pressure after an unexpected fall in retail sales last month raised the likelihood that Britain was slipping into its third recession in four years. The pound last stood at $1.5867, steady from late U.S. trade on Friday.
The Australian dollar, which came under a bit of profit taking late last week, continued to see good support under $1.0500. It was last at $1.0515, having bounced off a 1-1/2 week low of $1.0485 Friday.