Prepare for ‘Seismic Shift’ in Japan’s Politics and Economy

While the world's eyes have been turned towards the changing of the guard in neighbor China, Japan is braced for huge change in its political and monetary leadership in the next few months.

Forget the Euro, Here's Where the Action Is: Pro
Mike Kemp | Tetra images RF | Getty Images

The slow-growing Asian economy was at the front of market concerns for the first time in months Thursday, with a notably weaker yen and the Nikkei jumping nearly 2 percentage points. A weaker yen in the medium term could help boost sales at big Japanese exporters like electronics giant Sony, and consequently help stimulate growth.

Japan could move to sub-zero interest rates if, as looks likely according to recent opinion polls, opposition party LDP, led by Shinzo Abe, is elected.

Abe said Thursday that he wants the Bank of Japan (BoJ) to bring interest rates down to zero, or even below zero, to stimulate lending.

(Read More: Abe on Interest Rates)

He has previously called for the BoJ to embark on "unlimited" monetary easing to return to inflation after years of deflation. The current target for inflation is just 1 percent, but Abe wants to raise it to 3 percent.

"With Shinzo Abe a very vocal proponent of more aggressive BOJ policy easing in order to tackle deflation, the financial markets can now begin to price more confidently the risk of more overt political pressure on the BoJ to rid Japan of deflation," Derek Halpenny, European head of global markets research, Bank of Tokyo-Mitsubishi UFJ, wrote in a research note. "Pressure on the BoJ after a probable LDP election victory is likely to build."

Abe may get to enact his plans sooner rather than later. An election in December appears to be on the cards, after Prime Minister Yoshihiko Noda said he would dissolve the Diet — Japan's parliament — as early as Friday, as long as the opposition agrees to electoral reform.

Whoever is elected will have to pick a new Governor of the Bank of Japan in April, when incumbent Masaaki Shirakawa's term finishes. Since starting in 2008, Shirakawa has continued the policy of monetary easing, but failed to solve Japan's long-term issues with deflation.

(Read More: What Will Fix Japan's Economy?)

"There is a seismic shift in terms of the potential backstops for the Japanese economy," Jeremy Stretch, head of currency strategy at CIBC, told CNBC Thursday. "The Nikkei has had its fire lit by the move towards an election. Clearly that has pushed up dollar-yen significantly."

There are also worries that the Japanese government will downgrade its forecasts for economic growth for the fourth month in a row on Friday.

The Bank of Japan will meet for its regular rate-setting meeting on Tuesday.

"The BoJ have been struggling to get ahead of market expectations. If we were to see that unlimited intervention, that would help to keep the yen somewhat weaker than is sometimes the case. It continues to be well out of line with the underlying fundamentals," Stretch said.

Halpenny argued that real yen weakness will probably happen next year.

—Buy CNBC's Catherine Boyle; Follow Her on Twitter @cboylecnbc