The Bank of Japan will likely ease monetary policy next week, sources say, as looming risks such as the potential fallout from the U.S. fiscal cliff and weak Chinese growth continue to cloud the outlook for an economy already seen as in recession.
The most likely option is for the central bank to expand its asset-buying and lending program, currently at 91 trillion yen ($1.1 trillion), by another 5-10 trillion yen, at the meeting on Dec. 19-20, sources familiar with its thinking have said.
For now, many in the central bank want to hold off on any new initiatives unless the U.S. Federal Reserve, which holds its policy-setting meeting this week, surprises markets with a bigger-than-expected stimulus and triggers a sharp yen rise.
"What's important is the outlook for next year, which remains highly uncertain and dependent on overseas developments," said a source familiar with the central bank's thinking. "If the BOJ judges that its past easing measures aren't enough, it would have to do more this month."
Another source expressed a similar view. Both spoke on condition of anonymity due to the sensitivity of the subject.
The central bank has been under intense pressure to become bolder in its efforts to beat deflation ahead of a lower house election on Dec. 16, which polls suggest the main opposition Liberal Democratic Party (LDP) will win.
The party's leader, Shinzo Abe, has called on the BOJ to take steps such as "unlimited" easing to achieve 2 percent inflation, double the BOJ's current target.
(Read more: BOJ Should Keep Easy Policy Until Inflation 1 Percent: OECD)
Central bank policymakers, feeling the heat, are leaning toward action also because they reckon monetary easing in September and October may not have been enough to keep overseas risks from threatening Japan's recovery prospects.
"We took action in September and October because what we thought were risks back in the summer have materialized. We must debate and consider whether that was enough, taking into account various data which came out since then," BOJ Deputy Governor Kiyohiko Nishimura said last week, a view shared by many others on the nine-member board.
Board member Sayuri Shirai also warned that Japan's prices may undershoot the BOJ's projections. Two newcomers at the board, who called unsuccessfully in October to strengthen the BOJ's commitment to ultra-easy policy, also favor doing more to bring forward the end of deflation.
Japan's economy shrank for a second straight quarter in July-September and analysts expect another contraction in the final three months of this year, as a territorial row with China hit exports and hurt business sentiment.
A has done little to dispel policymakers' concern that weakness in manufacturing activity may spread throughout the economy as companies cut wages and delay capital expenditure.
Upcoming data is unlikely to offer much respite. The BOJ's closely-watched "tankan" survey due this week is likely to show that business sentiment worsened in the three months to December and companies plan to increase spending at a slower pace than initially expected.
The drag on exports from the U.S. fiscal cliff or a prolonged slowdown in Chinese demand may also threaten the BOJ's forecast that Japan will emerge from mild recession early next year, justifying an immediate policy response, the sources say.
The BOJ set a 1 percent inflation target in February and eased policy four times so far this year to show its determination to end deflation that has plagued Japan for more than a decade.