Ahead of a Bank of Japan leadership change, central bankers are considering the possibility of shifting policy closer to the quantitative easing campaign of the last decade, hoping it will give policy the kick demanded by Prime Minister Shinzo Abe.
Instead of focusing on reducing interest rates - which many see as a policy of diminishing returns since they are already at rock bottom - the central bank would shift to expanding its balance sheet, said sources familiar with its thinking.
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Such a shift would bring the central bank a step closer to making the purchase of longer-dated bonds a central part of policy and partly echoes Japan's five-year quantitative easing campaign that lasted until 2006, under which it aggressively pumped cash into the economy. "The BOJ's current policy is still about controlling interest rates. Shifting that focus to balance sheet expansion will open up a lot of possibilities in terms of policy options," said one of the sources.
The difference between the two approaches is a subtle one in that the central bank's current policy tool - a 101 trillion yen ($1 trillion) program of asset buying and lending - also expands the BOJ's balance sheet, which at a third of GDP is a bigger proportion of the economy compared with those of the U.S. and European Union's central banks.
But proponents suggest measuring the central bank's actions finally shaking Japanese out the psychology of deflation that has become entrenched during the past two decades. It will be easier to convince the public of the central bank's efforts to re inflate the world's third-biggest economy if they can easily measure jumps in the size of the BOJ's balance sheet, supporters of the idea say.
On the other hand, trying to push down interest rates that are already low has limited potential, they say. The central bank's policy rate is already set in a range of zero to 0.1 percent. Even 10-year Japanese government bonds yield only 0.6 percent.
Abe is demanding bolder steps from the central bank to help lift the economy out of deflation. In January, the central bank agreed to an inflation target of 2 percent. Expanding the balance sheet is just one of several ideas central bankers are studying internally ahead of the BOJ leadership transition.
Some still advocate sticking to a policy of nudging down interest rates further, such as by scrapping a 0.1 percent floor set on money market rates. Only after a new governor and deputy governors are in place in coming weeks will the nine-member board decide how to meet widespread expectations for the central bank to take more aggressive action to revive the long-moribund economy. "Nothing is decided, but it may be about thinking outside the box," said another source, who spoke on condition of anonymity due to the sensitivity of the matter.
But expanding the balance sheet is a strong possibility as it matches the reflationary policies supported by Abe's nominees for the top jobs, who have argued that printing money more aggressively will give a psychological boost to the economy. "The BOJ may initially try to settle with minor tweaks to its existing asset-buying program. But that won't be enough to satisfy markets and politicians," said Yasuhide Yajima, chief economist at NLI Research Institute in Tokyo. "Having a simpler target and policy framework will be key."
The easiest way for the central bank to ramp up the size of its balance sheet would be to buy longer-dated government bonds. The BOJ bought some longer-dated debt under the quantitative easing program of 2001-2006. But it pumped most of the cash into the economy via short-term money market operations, seen as a less risky option. Under its current asset-buying and lending tool, the BOJ limits the duration of government bonds it buys to three years because it wants to push down the cost of borrowing for companies, many of whom work in three-year investment cycles.
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It buys long-term government bonds, including those with durations longer than three years, in what is dubbed "rinban" market operations. This is separate from monetary policy and is seen as a regular market operation to offer long-term funds to the market. The BOJ currently makes the distinction because buying long-term government bonds for monetary easing could bind its hands on policy for longer than it wants and make a future exit from ultra-loose easing difficult. One line of thinking now is that the central bank may opt to combine the two programs and buy longer-dated bonds more aggressively, then set as its new target the total balance of bond holdings or the size of its balance sheet, the sources said. "This is a possibility if the BOJ wants to focus more on balance sheet expansion," a third source said.
Many in the central bank, including outgoing Governor Masaaki Shirakawa, are sceptical that monetary policy can impact public sentiment, so they do not buy into the idea that a change in policy would raise inflation expectations. Shirakawa's doubts kept the BOJ firmly focused on interest rates, rather than the size of its balance sheet, even after it had driven its policy rate down close to zero after the global financial crisis. Many central bankers have said the current BOJ policy is designed more to get corporate borrowing costs down than changing public perceptions.
Abe has tapped Asian Development Bank President Haruhiko Kuroda, an advocate of aggressive policy action, to head the BOJ. His nomination hearing in parliament is on Monday. Kikuo Iwata, an academic nominated to become deputy governor, has also consistently argued that the BOJ can boost inflation expectations and prompt companies to spend more by expanding its balance sheet aggressively.
He has said the BOJ needs to double the amount of current account deposits commercial banks placed with it to around 80 trillion yen to build expectations that inflation would rise to 2 percent. "Japanese companies have a lot of extra cash at hand because when there's deflation, the value of cash won't diminish even if they keep the money and not spend it on capital expenditure," Iwata told Reuters in an interview in January. "If the BOJ can manage to boost inflation expectations, that huge pile of money will be spent more on capital spending."