TOKYO (Reuters) - Bank of Japan Governor Masaaki Shirakawa said the central bank will continue with powerful monetary easing as the economy is likely to remain weak for the time being, hardening market expectations that it will expand stimulus again this month.
Prime Minister Shinzo Abe kept up pressure on the central bank ahead of its policy-setting meeting next week, repeating his call for bolder monetary easing in talks with economic aides on Tuesday.
Shirakawa stuck to the central bank's view that the economy will eventually resume a moderate recovery as overseas growth gradually emerges from a slowdown, helped in part by resilience in domestic demand.
But he warned that the outlook remained highly uncertain, pointing to risks such as a continued slowdown in overseas growth and a diplomatic row with China that has hurt sales in one of its biggest export markets.
"Exports and factory output are declining as overseas economic growth continues to slow," he told a quarterly meeting of the central bank's regional branch managers on Tuesday.
The BOJ is under intense pressure from Abe, whose party surged to power in a lower house election in December last year, to take bolder action to beat deflation.
The central bank, which eased policy five times in 2012, will thus consider expanding stimulus again and double its inflation target to 2 percent at the rate review on January 21-22, sources have told Reuters.
Expectations of further easing have weakened the yen and nudged up Tokyo's Nikkei share average to a 32-month high on Tuesday, offering a relief to Japan's exporters struggling from slumping global sales.
But Economics Minister Akira Amari warned that excessive yen weakness could have its own drawbacks by boosting the cost of imports, which triggered a yen rebound from its 2-1/2-year low.
"Yen falls are good for exports, but excessive yen weakness affects import prices and could have a negative effect on people's livelihood," Amari told a news conference.
The world's third largest economy slipped into a recession that analysts say began in the first half of 2012 as the global slowdown and weak sales to China hit exports and factory output.
Many analysts expect the economy to emerge from recession by mid-year as overseas growth picks up, although Japan has been waging a long battle to escape deflation that has plagued the country for nearly two decades.
The BOJ cut its assessment of eight of Japan's nine regional economies, the first time in four years that it made downgrades for so many regions for two straight quarters, in a sign of the broadening pain from slumping exports.
"Business sentiment, mainly that of manufacturers, is worsening. Capital expenditure is weak as a whole, although resilience is seen in non-manufacturers' spending," Shirakawa told the branch managers' meeting.
The gloomy assessment will give the BOJ justification to ease again next week, although any further stimulus will be more in response to unrelenting pressure from Abe, analysts say.
The central bank is vulnerable to political interference as Abe has the power to choose a candidate to succeed Shirakawa, whose term expires in April. Abe's nomination, however, needs approval by both houses of parliament to take effect.
Abe invited his economic advisers, most of them vocal advocates of aggressive BOJ easing, to his official residence on Tuesday to hear their views on monetary policy.
"The prime minister said the BOJ's monetary easing was particularly important for Japan to beat deflation," a government official told reporters after the meeting.
The discussions were based on the assumption that the BOJ will issue a joint statement with the government, the official said.
The government is negotiating with the BOJ to issue such a statement to make the bank accountable to achieving 2 percent inflation target, double its current goal set in February last year.
The central bank is likely to accept Abe's calls for a medium-term target of 2 percent inflation, but is opposed to setting a specific deadline for achieving it and adding job growth to its mandate for fear of binding its hands on future monetary policy.
The statement is expected to be issued after the BOJ's policy meeting next week, when the central bank will also conduct a quarterly review of its long-term economic forecasts.
The BOJ is set to cut its economic forecast for the current fiscal year ending in March from a 1.5 percent expansion projected three months ago, sources said. A Reuters poll in December produced a median forecast for the economy to grow 1.0 percent in the current fiscal year.
Additional reporting by Kaori Kaneko, Tetsushi Kajimoto, Stanley White and Yuko Yoshikawa; Editing by Simon Cameron-Moore