* What: Two-day Bank of Japan policy-setting meeting
* When: Outcome announced between 0330-0500 GMT
* Reuters forecast: No change in rates, no new initiatives
By Leika Kihara
TOKYO, Dec 18 (Reuters) - The Bank of Japan is expected to keep interest rates unchanged and hold off on new initiatives in a rate review ending on Friday, saving further easing for when government pressure may increase next year as deflation erodes demand.
The central bank can afford to stand pat on policy, having relieved some pressure by putting in place a new funding operation just two weeks ago.
But with deflation seen persisting and the government fretting about weakness in the economy, the BOJ may debate what options it has to loosen monetary policy early next year when the effect of domestic stimulus measures fades.
For now, the BOJ is seen highly likely to keep its benchmark overnight call rate target at 0.1 percent.
The government, in office for just three months, is determined to keep the economy from slipping back into recession ahead of an election for parliament's upper house in mid-2010.
At an emergency meeting on Dec. 1, the BOJ decided to offer three-month funds to banks at 0.1 percent, buying itself some space after weeks of pressure from the government to do more to support the economy.
The BOJ considers the operation, which it described as quantitative easing in a broad sense, a powerful tool to push down the short end of the yield curve and hopes to use it as much as possible before embarking on further monetary easing.
Auctions of the new operation have met with strong demand, while three-month yen TIBOR has dropped to around 0.46 percent from about 0.51 percent at the end of November.
While the BOJ is unlikely to tweak an operation set up just two weeks ago, expanding it could emerge as an option early next year if a worsening economy escalates government pressure for more monetary easing.
If Japan slips into another recession or concern over the country's huge public debt pushes up bond yields, the central bank may come under pressure for more aggressive action, such as increasing its purchases of government bonds.
The BOJ forecasts three years of deflation and has said it will keep monetary conditions accommodative for as long as needed.
But it has been reluctant to increase long-term government bond purchases from the current 21.6 trillion yen ($240.9 billion) per year, arguing that the balance of its bond holdings was already nearing a self-imposed cap. ($1=89.66 Yen) (Editing by Chris Gallagher)