TOKYO A victory by power broker Ichiro Ozawa in the leadership race for Japan's ruling party next week raises the risk that the central bank's next policy move will be to buy more government bonds -- something it has long resisted.
The central bank has argued that increasing its bond buying -- currently capped at 21.6 trillion yen ($257.6 billion) a year -- would damage its credibility by giving financial markets the impression it will print money at the government's behest.
But the BOJ may not have much choice if political pressure for more action to boost the economy escalates. Indeed, some central bankers acknowledge the next policy move could be to boost bond purchases to fund Ozawa's spending plans.
"Ozawa wants to boost spending but won't find much money to fund it, so will certainly want the BOJ's help," said Takeshi Minami, chief economist at Norinchukin Research Institute.
"The BOJ already floods markets with more short-term cash than commercial banks need. The next step would be for it to boost long-term fund supply by buying more government bonds."
Prime Minister Naoto Kan has a slight edge over Ozawa ahead of next Tuesday's Democratic Party leadership vote, Japanese media say, but the outcome is too close to call.
The winner becomes prime minister by virtue of the party's majority in parliament's powerful lower house.
Ozawa has said he wants to carry out the ruling party's costly spending programs promised in last year's general election and that issuing more new bonds is one way to do it.
Expectations that Ozawa could be a less of a fiscal reformer than Kan has already led to a steepening of the bond yield curve on investor worries that Japan will see further increases in its public debt, which is already twice the size of its economy.
Tsutomu Okubo, a ruling party lawmaker who is helping formulate economic policy for Ozawa, told Reuters on Friday the BOJ should expand its outright government bond buying to help beat deflation.
BOLDER ACTION REQUIRED
The BOJ has been under government pressure since late last year to loosen its already ultra-loose monetary policy -- the policy rate is just 0.1 percent -- as the economy stumbled out of the global downturn.
The government has argued that its debt load leaves it with little room to boost the economy.
Weak domestic demand is keeping the economy in deflation and policymakers are increasingly concerned that demand for Japan's exports could be crimped by a rise in the yen to 15-year highs.
The BOJ is expected to ease policy next month while predicting a delay in Japan's exit from deflation.
"Ozawa seems to be clear on what he wants and could focus on achieving his goals than respecting the BOJ's independence," said Jun Fukashiro, chief fund manager at Toyota Asset Management's investment management department.
"The BOJ may ease if continued yen rises pose serious harm to the economy. A possibility would be to expand its balance sheet such as by increasing its government bond purchases."
Three policy moves since December, centered on a cheap bank loans program, have had little impact on the economy. In fact, the economic recovery is seen slowing later this year.
So there is a growing sense in the BOJ that the central bank needs to take bolder action to send a clear message to financial markets that it is determined to boost the economy.
Governor Masaaki Shirakawa prefers buying time with small incremental steps rather than taking more aggressive action, such as increasing government bond purchases.
The BOJ tripled its buying of government debt when it adopted quantitative easing from 2001 to 2006, as part of measures to meet a liquidity target it had set to lift the economy.
Shirakawa, who at the time was a senior BOJ official, is wary of repeating the policy because he argues the move did little to boost the economy and beat deflation.
But he may be persuaded that bond buying is the best option.
Bond yields are low for now but Ozawa's preference for spending could push them higher, putting further pressure on the fragile recovery, analysts say.
That may persuade Shirakawa that bond buying is easier to swallow than a return to zero rates, which would take away any incentive for banks to trade with each other, effectively destroying the money market.
"As the governor has said, the BOJ is considering various options," a source familiar with the bank's thinking said, adding that a moderate increase in bond buying was not ruled out.
"It's not an ideal option for the BOJ but it's possible, and would surely give markets a surprise," said another source. Both declined to be identified due to the sensitivity of the matter.
If history is anything to go by, the BOJ would increase its bond purchases by around 200 billion yen per month.
A bigger amount would mean the BOJ would have to review its self-imposed rule of capping government bond holdings to the amount of bank notes in circulation, something sources say it is not ready to do just yet.
(Additional reporting by Kaori Kaneko, Tetsushi Kajimoto; Editing by Neil Fullick)