The Bank of Japan upgraded its economic assessment on Friday, setting itself up for a confrontation with a government pressing for a policy response to deflation and a possible return to recession.
The Japanese government published a report that pronounced the economy officially in deflation for the first time since 2006, and the finance minister said he wanted the BOJ to "respond appropriately".
Having rebuffed government appeals last month to extend support for credit markets, the central bank may soon find itself under pressure to buy more government bonds as rising yields threaten an economic recovery, analysts said.
"By declaring that Japan is in deflation, the government is trying to persuade the BOJ that it needs to do something," said Takeshi Minami, chief economist at Norinchukin Research Institute.
"At present, the governor doesn't seem to be taking price falls too seriously. At least, the BOJ doesn't seem to want to take further action. I think the government is trying to change that."
The central bank held its benchmark rate at 0.1 per cent after a two-day policy review and appeared to suggest the ball was in the government's court.
"The cause of sustained price falls is a lack of demand," governor Masaaki Shirakawa told a news conference after the government published its report.
The central bank was doing everything it could to provide liquidity to the economy including by keeping interest rates very low, he said.
"When demand itself is weak, prices won't rise just through liquidity provision," Mr. Shirakawa said.
Forced To Do More
That was an attempt to deflect government pressure, said Koji Ochiai, senior market economist at Mizuho Investors Securities.
"If share prices fall more or if the yen strengthens much more, the BOJ might be forced to take more steps," he said.
"It can either say explicitly that low interest rates will stay for an extended period, just like the Fed does, or it could increase its purchases of government bonds."
The BOJ buys 21.6-trillion yen ($243-billion) of Japanese government bonds each year and is reluctant to increase purchases, arguing that its government debt holdings are already approaching its self-imposed ceiling.
"The BOJ will be on hold for a long time to come," said Adrian Foster, head of financial markets research at Rabobank International, Hong Kong.
"The government still has some room to boost demand, but with the public sector deficit already so large, there are not many levers left across the board."
Rising bond yields and the risk of a credit rating downgrade have hamstrung government efforts to stimulate the economy and avoid what it fears will be a second recession early next year.
Japan's government debt burden - at nearly 200 per cent of gross domestic product - is the heaviest of any rich nation, and concerns about Japan's fiscal health helped widen the spread between two-year and 10-year bond yields to a 3-1/2-year high of 121 basis points last week.
Japan's sovereign five-year credit default spread widened to around 77 basis points early last week, its highest since April.
Finance Minister Hirohisa Fujii said on Friday rising bond yields could undermine government efforts to help small companies, flagging the same concern he and other government officials cited as they pressed the BOJ to extend corporate debt buying beyond December.
"Monetary policy is absolutely vital. It is like the lifeblood of the economy, so I want the BOJ to respond appropriately," Mr. Fujii told a news conference.
The BOJ said it would maintain very easy monetary conditions.
It dropped a more specific pledge to keep rates low for some time, a line it inserted into a statement last month when it announced it would scrap some support for credit markets.
While that line appeared to have been inserted to placate a worried government, the BOJ's decision to upgrade its view on the economy on Friday was likely to provoke a strong response.
"Recent price developments show that the Japanese economy is in a mild deflationary phase," the government said in its report on the economy.
The report did not say how it wanted the central bank to tackle deflation. The OECD on Thursday urged the BOJ to keep interest rates low and buy more government bonds to help beat deflation.
Follow us on Twitter: