Q+A-Is the Bank of Japan losing credibility?

By Rie Ishiguro and Leika Kihara

TOKYO, March 12 (Reuters) - The Bank of Japan is leaning towards easing monetary policy again next week, sources said, after weeks of government pressure for action to combat grinding deflation.

Some BOJ policymakers think loosening policy is not justified since the economy is slowly emerging from the global economic downturn along the lines of central bank expectations.

Without a convincing reason to ease its already ultra-loose policy, the BOJ risks undermining its credibility as an independent central bank.

Here are some questions and answers on how the BOJ has dealt with this pressure and the implications for its credibility:

WHY IS BANK OF JAPAN CREDIBILITY AN ISSUE NOW?

In recent months, the Bank of Japan seems to have been following the lead of the government over how to manage the economy.

It buckled under government pressure in December and eased already ultra-loose monetary policy by introducing a three-month lending operation at the policy rate of 0.1 percent.

The BOJ also followed the government in declaring that Japan was in deflation. It then said it would not tolerate zero price growth, let alone deflation.

That was an about-face because up until then it had been reluctant to say Japan was in deflation.

Now, the BOJ is poised to ease policy once again after weeks of needling by the government to defeat deflation, sources said. The so-called core-core consumer price index, similar to the core index used in the United States, has been falling for 13 straight months.

The index excludes food and energy prices that can be highly volatile.

WHAT DOES THE LAW SAY ABOUT THE CENTRAL BANK'S STATUS?

The BOJ is independent by law, but it is not a clear cut issue since the government wields influence. The same law, for example, requires the central bank to communicate with the government to ensure their policies are aligned.

The government picks all nine members of the BOJ policy setting board, including its governor. But it can't sack anyone.

Representatives from the finance ministry and Cabinet Office also attend the policy-setting meetings. They cannot vote but can voice their views and request delays in votes.

The latter is rarely used. The last time was in August 2000, when the BOJ ended its zero interest rate policy. The board rejected the request and raised rates to 0.25 percent, only to ease again eight months later by adopting quantitative easing in the face of government criticism.

WHAT DOES THE GOVERNMENT WANT THE CENTRAL BANK TO DO?

Finance Minister Naoto Kan says he would like to see deflation end this year, although he concedes that is more of a hope than a goal.

The government is worried that deflation, partly the result of weak domestic demand, will push the economy back into a downturn. It emerged from its longest recession in decades in the second quarter of 2009 but deflation has lingered.

Kan says inflation around 1 percent is desirable, a level that the BOJ says would define long-term price stability, its main policy objective.

But the mere mention of a specific figure and a deadline is a way of putting pressure on the BOJ to ease policy further. While recognising that getting rid of deflation this year is unlikely, Kan may simply be seeking more urgency from the central bank to act.

WHAT WILL THE BOJ DO?

The BOJ is leaning towards easing policy next week by adding to the funds available under its three-month lending operation or offering loans for longer, sources told Reuters this week.

But the board is split, the sources said. Some members are worried that loosening monetary policy is not justified since the economy is recovering from the global crisis in line with BOJ official expectations.

The BOJ has maintained it will ease policy if economic and price moves deviate sharply from its forecast, or if a sudden market shock threatens a recovery.

The BOJ would probably justify loosening policy by pointing to record annual falls in Japan's core-core consumer price index and how that could affect public price expectations.

HOW WOULD THIS HURT THE BOJ'S CREDIBILITY?

Easing policy without changing its assessment of the economy and prices would leave the BOJ open to criticism that it is being influenced by political pressure.

That would make it harder for markets to predict how and when the BOJ will move, heightening market volatility. Whenever the government grumbles publicly about the BOJ, markets may factor in the chance of a policy change.

A loss of market confidence in the BOJ could hurt the value of the yen. Bond yields may also rise if concern grows that the BOJ is moving towards a policy of printing money to finance government spending.

WOULD MORE EASING HELP THE ECONOMY?

Not much, at least in the near term.

By showing its determination to fight deflation, the BOJ instead hopes it can boost sentiment and prevent companies and households from holding back their spending. But such an effect on sentiment will be very hard to measure.

The yen's strength is viewed as a factor warranting further easing because a stronger yen hurts the fragile economy through the substantial exports industry. But the BOJ would not publicly link its policy to currency moves. (Editing by Neil Fullick)