Within a day of Shinzo Abe's Liberal Democratic Party sweeping to power in elections this month, elite bureaucrats in Japan's central bank rushed to ready what amounted to a surrender offer.
Abe had run his campaign with a relentless focus on economic policy and had called on the Bank of Japan (BOJ) to take drastic steps to end the nation's long bout of deflation, or else face a radical makeover at the hands of parliament.
The vote had become an unexpected referendum on the BOJ itself, and the bank had lost. Senior officials concluded that to preserve the BOJ's scope to act in a future crisis, it needed to move quickly to show it recogniszd reality, according to people familiar with the hurried deliberations.
Abe had won a mandate for more forceful monetary easing, and Japanese taxpayers were frustrated with an economy slipping back into its third recession in five years. In the early afternoon of Dec. 18, two days after the vote, BOJ Governor Masaaki Shirakawa was to pay a courtesy call on Abe. But even before then, a post-election plan had taken shape: the BOJ would consider the kind of ambitious 2 percent inflation target that Abe had insisted was needed to pull Japan out of nearly two decades of deflation and diminished expectations.
It was an about-face for Shirakawa who, since taking his post in 2008, had argued that by focusing too narrowly on consumer prices, the BOJ could miss signs of an asset price bubble like the one Japan experienced in the late 1980s. But increasingly his own senior officials and members of the BOJ's policy-setting board were ready to take risks and test unorthodox and unproven measures that Shirakawa had long resisted, such as an unlimited debt-fuelled monetary expansion, officials familiar with their thinking say.
"The LDP's win was just too big, and it won an election calling for a 2 percent inflation target. If that's the will of the people, the BOJ must respect that," said a source familiar with the central bank's thinking. "Otherwise, the BOJ could lose everything, including its independence."
The central bank is now on track to pump 120 trillion yen ($1.4 trillion) into the economy - equivalent to the value of six Googles - even though skeptics argue that this tide of money cannot break Japan's real economic logjam: falling wages. Instead, the skeptics say, the risk is that investors would end up concluding that Japan needed the central bank to cover its debts - a recipe for a selloff of government bonds, which already amount to twice the size of gross domestic product.
But after Abe's landslide election victory - and years of limited money-printing having failed to revive growth - senior BOJ officials wanted it understood they were ready to join the experiment in what media and investors called "Abenomics", a potentially high-octane mix of fiscal and monetary stimulus.
Abe's victory seemed to establish that millions of Japanese shared his views, people in the bank came to believe. They felt he now held the trump card in any future standoff with the BOJ over monetary policy - a mandate to amend the BOJ Law in a way that would give the government power to impose a binding target on the central bank, or fire its governor.
In a symbol of the political significance of his monetary policy push, Abe scheduled a one-on-one meeting with Shirakawa just hours after setting up a first phone call as prime-minister-elect with the U.S President Barack Obama. Two days after the election, the central bank governor visited Abe at the fortress-like headquarters of the Liberal Democratic Party (LDP).
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Abe reminded Shirakawa of his campaign promises. He wanted to see the BOJ sign a "policy accord" that would oblige it to support Abe's reflationary agenda and commit to a 2 percent inflation target, Abe told reporters later. After the meeting, Shirakawa rushed through a scrum of reporters into his waiting car and declined to say what was discussed. However Abe, in another break with protocol, gave an unusually detailed recounting of the 15-minute meeting. "The governor just listened," he said. The next day, the BOJ began a scheduled two-day policy board meeting.
The central bank announced its third shot of monetary stimulus in four months by adding another 10 trillion yen to its asset-buying program - essentially committing to create more money to buy government debt. It marked the fifth time this year that the central bank had expanded asset purchases - its most active year in terms of monetary expansion in a decade. More significantly, the BOJ also made a direct concession to Abe and pledged to review its existing inflation target of 1 percent at its next scheduled meeting in January.
The BOJ was retreating from the cautious stance of its classically trained boss, Shirakawa, and essentially turning a blind eye to the potential, long-term drawbacks of excessive money printing that he had long warned about. Only a month earlier, many BOJ officials had preferred to hold off on taking action until the January meeting, according to sources familiar with the deliberations. Shirakawa, in particular, had been in no mood to act again in 2012, let alone commit to studying a higher inflation target.
He had been convinced that the BOJ's monetary easing steps in September and October were enough to stave off risks to the economy for now, the sources said.
Long & Winding Road
Shirakawa's five-year term ends in April and people close to him say he has no interest in staying on. But decisions taken under his watch over the next few months could influence the central bank's credibility well beyond his departure. A fan of the Beatles, Shirakawa, 63, has often warned against the risk of an overly loose monetary policy. He once described Japan's struggle to recover from its late 1980s asset bubble as "The Long And Winding Road", a reference to the plaintive Beatles song. He said rich economies risked repeating Japan's "lost decade" of slow growth if they kept ultra-easy monetary policy in place for too long.
But for the past year, a tight-knit group of officials in the BOJ's Monetary Affairs Department has been nudging the bank in the opposite direction. They favour more aggressive easing, such as a big increase in government bond buying, according to officials with knowledge of those discussions and former central bank officials who remain in close contact with policymakers.
(Read More: Weak Japan Data Bolster Abe's Hand on Stimulus)
Among the actions now under consideration at the BOJ is an open-ended commitment to buy government bonds or an expansion in the type of assets it purchases, the officials said. Another idea, floated by board member Koji Ishida, is to nudge rates to zero by scrapping a 0.1 percent interest rate the BOJ pays on excess reserves parked with the central bank.
Proponents argue that such steps would hold down interest rates on bank and corporate borrowing, encourage money to flow to private investors and help weaken the yen. Anticipation of BOJ action has already pushed the yen to a two-year low against the dollar.
Tokyo stock prices have climbed to a 21-month high on the expectation for higher earnings for currency-sensitive exporters like automaker Toyota Motor Corp. "Markets already expect the BOJ to set a 2 percent inflation target, so the question now is what the central bank would do to achieve it," said Masaaki Kanno, a former central banker and now chief economist at JPMorgan Securities in Tokyo. "If it wants to influence currency rates, it needs to give markets the impression it is easing aggressively." Abe has said he will choose a successor to Shirakawa whose views are closer to his own.
He has not made up his mind yet on his favoured candidate but aides say he may prefer someone with negotiation and management skills, rather than an academic, to oversee the BOJ as it pushes into unknown territory.
Pressure Remains On
With the LDP's coalition partner, the New Komeito, Abe has enough votes in the lower house to overrule the upper house on key votes, including a potential revision of the 1998 BOJ Law that gave the 130-year-old bank its long-awaited independence. Under this law, the central bank is guaranteed independence to guide monetary policy without political interference and is mandated to pursue price stability.
Abe has discussed a law revision to impose a price target on the central bank and add a requirement to maximize job growth to its mandate. Abe is already using threats of a BOJ Law revision to nudge the central bank into meeting his demands. Koichi Hamada, a Yale University professor whom Abe admires, said the BOJ would have to accept more legal accountability to achieve its price target and beat deflation.
"Generally speaking, the BOJ is making an effort. But there is hardly any change to its pace of 'too little, too late'," said Hamada, 76, who was appointed a special adviser to Abe's cabinet and also taught Shirakawa at the University of Tokyo. "It is necessary to amend the BOJ law," he said in a telephone interview on Thursday.
'A Tough Spot'
One challenge now for the BOJ is setting a higher inflation target that is seen as credible. In February, the BOJ said that it would aim to achieve 1 percent price growth. But Shirakawa, who joined the BOJ during Japan's high inflation years of the early 1970s, and many other officials in the bank have resisted calls for a higher target. For one, Japan has not seen 2 percent inflation in the past two decades.
The last time it did was during the real estate and stock market bubble of the late 1980s to early 1990s, when the BOJ was criticized for missing signs of an overheating economy. Some officials share Shirakawa's doubts over whether further monetary easing will work.
Two key metrics - the BOJ's holdings of government debt and the balance of deposits parked with the central bank - are already at record highs, yet the BOJ's pump-priming measures have failed to put an end to deflation. Nationwide core consumer prices slid 0.1 percent in November from a year earlier after flat growth in October, which followed five straight month of declines.
Another concern for the cautionary wing of the BOJ centers on the unusual structure of Japan's economy. Japan's jobless rate - at 4 percent - is half that of the United States. But wages remain on the decline, down 1.1 percent in November from a year earlier to mark the third straight month of falls. Unable to fire workers in mass layoffs because of rigid labour rules, Japanese firms are unwilling to raise salaries.
Without a rise in wages, the only practical way overall prices could go up would be through higher commodity and fuel costs which would curb consumption, not boost it, the BOJ has argued. Setting a 2 percent inflation target next month would require the BOJ to awkwardly steer around the arguments that Shirakawa and other officials have long made.
"If the BOJ contradicts too much of what it's been saying all along, that would put its credibility on the line. People will no longer believe what the BOJ says anymore," said Izuru Kato, chief economist at Totan Research Institute in Tokyo. The BOJ also worries about a potential bond-market backlash. Its ultra-easy policy has pushed down five-year bond yields below 0.2 percent. But some investors balk at buying too many 20-year and 30-year bonds, concerned that Abe's pledge of big fiscal spending would strain Japan's already worsening finances.
Much will depend on Shirakawa's successor and how well the central bank communicates its policy target to investors - an area where Shirakawa has struggled by his own admission. After the Dec. 20 easing, his aides convinced him to try the kind of visual aid often used on Japanese television - a large flip chart - and to aim his presentation at the TV cameras. An economist suspicious of sound bites, he looked uncomfortable.
"The BOJ is pumping huge amounts of money and easing very aggressively. But that fact isn't understood well perhaps because of our restrained character. There's a huge perception gap," Shirakawa said. "I hope this chart is broadcast on television and helps more people understand our point," he added.