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TOKYO (Reuters) - The Bank of Japan resisted political pressure for action and kept monetary policy steady on Friday, but left the door open to more monetary easing later this month by warning of looming risks to the outlook for the world's third-largest economy.
Despite mounting signs that sagging exports to China and Europe may nudge Japan into recession, central bankers preferred to wait and assess the effect of stimulus unveiled just last month, and save their limited options for now.
Underscoring heightening pressure from the government, newly appointed Economics Minister Seiji Maehara, a vocal advocate of aggressive monetary expansion, made a rare appearance at Friday's meeting to make a direct call for bolder action.
"I'd like to continue urging the BOJ to pursue powerful monetary easing to achieve its price target," Maehara told reporters after attending the rate review, becoming the first economics minister to do so in nearly a decade.
Markets see a strong chance that the BOJ will loosen policy again on October 30. It is also expected to cut its long-term growth forecasts at that meeting and admit that Japan remains years away from achieving the bank's 1 percent inflation target in around fiscal 2014, according to sources familiar with its thinking.
"Downward pressure on the economy and prices is increasing, so keeping policy on hold at the BOJ's next meeting may not be an option," said Hiroshi Miyazaki, chief economist at Shinkin Asset Management in Tokyo.
As widely expected, the central bank held off on expanding its asset buying and loan program, after having increased it last month on fears that weak exports and output are diminishing prospects of a near-term recovery.
But it warned that Japan's economic activity was leveling off, offering a slightly bleaker view than last month when it said a pickup in growth was pausing.
"The slowdown in overseas growth is lasting somewhat longer than expected, which is affecting manufacturers' exports. The impact may gradually spread to other parts of the economy," BOJ Governor Masaaki Shirakawa told a news conference.
The BOJ set a 1 percent inflation target and eased policy in February, and followed up with additional stimulus twice so far this year in a show of its determination to beat deflation that has plagued the country for most of the past decade.
It now projects core consumer inflation, which excludes food and energy, of 0.2 percent for the current business year ending in March 2013, and 0.7 percent in the following year.
Analysts have criticized the forecasts as too optimistic, noting core consumer prices fell 0.3 percent in August from a year earlier to mark the fourth straight month of declines.
Pushing the BOJ's inflation target back would make a case for immediate policy action, analysts say.
But Shirakawa stressed that the BOJ will not bind its policy decisions to its price outlook, signaling that falling short of its 1 percent target would not guarantee imminent easing.
"What's important is whether prices are heading up as a trend, rather than short-term moves," he said. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
Global interest rates link.reuters.com/xyb96s
Central bank balance sheets link.reuters.com/jyh34s
So far this year, Japan's economy has outperformed most of its peers in the Group of Seven on spending for rebuilding from last year's earthquake. But with that effect fading, domestic demand may not make up for falling exports for much longer.
Output fell to a 15-month low in August on sagging sales to top export market China and business sentiment soured in the three months to September, fuelling concerns that the world's third-largest economy has stalled and may slip into recession.
Anti-Japan protests in China have added to headaches for Japanese companies. Toyota Motor Corp's (7203.T) China sales fell about 40 percent in September, underscoring how badly the territorial row is hitting Japanese brands.
Pressure from the government will keep the BOJ on edge.
Two government representatives, one from the finance ministry and another from the Cabinet Office, which Maehara heads, can attend the BOJ's policy meetings. They cannot vote but may express views and propose a request in vote on policy.
The BOJ, however, is running out of tools to force-feed cash to markets already awash with excess funds.
It needs to pump 20 trillion yen ($255 billion) more into markets by the end of next year to achieve the 80-trillion-yen target set for its asset buying and loan program, under which it offers funds via market operations and buys government bonds, corporate debt and trust funds investing in stocks and property.
That is not easy because commercial banks, struggling to find companies eager to borrow amid a weakening economy, are in little need of cash and so are stacking money in BOJ accounts.
Maehara has urged the BOJ to buy foreign bonds. But this will require a revision to current law that prohibits the BOJ from buying foreign assets to influence currency rates.
That means the most likely path would be for the central bank to continue boosting government bond purchases, sources have said, adding that there is still room to pledge bigger amounts of bond purchases for next year.
($1 = 78.4500 Japanese yen)
Additional reporting by Stanley White, Kaori Kaneko and Tetsushi Kajimoto; Editing by Kim Coghill