* Pressure builds on BOJ to follow U.S. lead and slash rates
* What: Bank of Japan two-day policy meeting
* When: Rate decision Dec 19 likely 12-2 p.m. (0300-0500 GMT)
By Leika Kihara
TOKYO, Dec 17 (Reuters) - A dramatic rate cut by the U.S. Federal Reserve has ratcheted up the pressure on a reluctant Bank of Japan to follow suit this week, with analysts saying to hold back would rock Japanese markets and worsen the crisis.
Some analysts suggested the Japanese central bank could also cut rates to almost zero on Friday, whereas before the Fed move the BOJ was seen as ready to take more steps to ease a credit crunch but undecided about cutting rates.
The U.S. Federal Reserve broke into uncharted territory by chopping benchmark rates to as low as zero and pledging to use "all available tools" to turn back a deepening recession.
As government officials pushed the BOJ to take more action, investors saw a 60 percent chance of it cutting rates to 0.1 percent from its current 0.3 percent.
"With the Fed having come this far, markets would be hugely disappointed if the BOJ keeps rates on hold at 0.3 percent this week. The rate differential could trigger sharp yen rises and push down stocks, reviving the market crisis in October," said Hirokata Kusaba, senior economist at Mizuho Research Institute.
"The BOJ needs to do something and I'm sure they are aware of that. It's likely to cut rates, even to zero, this week. It needs to avoid keeping Japanese rates higher than those of the U.S."
In further pressure, chief government spokesman Takeo Kawamura, a cabinet minister, said the BOJ must support the economy.
"The abnormal rise in the yen could affect export industries and I hope that the BOJ will make a comprehensive consideration, including those factors, to decide its monetary policy," Kawamura told a news conference.
The Fed's surprisingly big rate cut sent Japanese government bonds surging and the yen back towards 13-year highs against the dollar, to the likely dismay of a BOJ worried about the strong yen's impact on Japanese exports.
The yen was seen rising further against the dollar with U.S. interest rates now lower than Japan's, adding pressure on the BOJ to slash rates, analysts said.
SEVERE CONDITIONS
BOJ Governor Masaaki Shirakawa added fuel to the fire on Tuesday, when he warned Japan's economy was in severe condition and monetary conditions were rapidly becoming less accommodative -- his bleakest prognosis yet.
Central banks across the globe are slashing rates and eyeing unorthodox policy measures as the global financial crisis sends many rich countries into recession and slows growth in China and India.
Japan, like the United States, is already in recession as companies such as carmakers Toyota and Honda slash output as customers close their wallets worldwide.
But the BOJ decision this week could be a close call as some within the central bank are reluctant to cut already low rates further.
They argue that doing so would do little to boost the economy, preferring instead more moves to ease tight credit.
These steps could include expanding the type of collateral it accepts in its fund operations.
The BOJ could follow the Fed into buying commercial paper outright or purchase asset-backed securities, reviving a scheme that was put in place five years ago during the bank crisis.
Commercial paper is a form of short-term unsecured borrowing often used by companies to fund day-to-day operations
Other steps being floated are for the BOJ to boost the amount of long-term Japanese government bonds it buys outright each month from the current 1.2 trillion yen ($13.5 billion) or expand the type of assets it accepts in fund operations, analysts said.
"The BOJ can't get away with doing nothing, but past experience shows it is always behind the curve in acting against market moves," said Yasuhide Yajima, senior economist at NLI Research Institute.
"The chance of the bank cutting rates this week is 50-50."
The collapse in global demand has forced leading Japanese companies such as Sony and Canon to slash jobs and investments and the yen's strength is threatening to further erode their export earnings.
With its own tankan survey showing the biggest plunge in business confidence since the 1970s oil crises, the BOJ is set to downgrade its already bleak economic assessment, analysts say.
The BOJ cut its key policy rate to 0.3 percent from 0.5 percent in October and unveiled a series of measures to ease credit strains as the fallout from the global financial turmoil spread.
But that had done little to ease the seized up commercial paper market, which has forced Japanese companies to boost borrowing from banks at a record pace as they hoard cash on jitters over of a year-end credit squeeze.
Currently, the Bank of Japan buys commercial paper in its market operations to provide funds to banks, but only with a re-sale agreement rather than buying the debt outright. ($1=88.99 Yen) (Editing by Rodney Joyce)