(For more stories on the Japanese economy, click [ID:nECONJP])
By Leika Kihara
TOKYO, Aug 6 (Reuters) - The Bank of Japan is expected to keep monetary policy on hold next week and examine whether weakness in household and corporate spending could threaten its forecast of a modest pickup in the economy later this year.
The central bank looks poised to keep its overnight call rate target at 0.1 percent and refrain from any new policy initiatives at its two-day rate review that ends on Aug. 11, but markets will watch out for any changes in its language on the outlook for the world's second-largest economy.
Here are some possible outcomes of the meeting, as well as possible market responses:
KEEPS ASSESSMENT: ECONOMY BOTTOMING OUT, OUTLOOK UNCERTAIN
PROBABILITY: High.
The BOJ will most likely maintain its view that Japan's economy is bottoming out as exports and output rebound from a sharp downturn triggered by the global financial turmoil.
Industrial output marked a record quarterly rise in April-June and is expected to increase again in July-September as stimulus spending buoys demand for cars and consumer electronics.
BOJ Governor Masaaki Shirakawa, however, will probably repeat his caveats that the outlook remains highly uncertain and that downside risks persist.
MARKET IMPACT: Financial markets may read this as a sign the BOJ is not inclined to let its unconventional policy steps aimed at easing corporate financing strains expire in December. That would help push down money market rates and bond yields, although any reaction will be muted as interest rates have already been stable lately.
Last month, the central bank extended the extraordinary measures by three months beyond the original September deadline, instead of the widely expected six months, in response to improving credit markets. [ID:nT132248]
Since the decision was just made at the previous meeting, the BOJ is unlikely to discuss a new deadline.
DEBATE STIMULUS IMPACT, BOJ FORECAST
PROBABILITY: Likely.
While still three months away, some board members already have their eyes set on the BOJ's twice-yearly economic and price outlook report due in October.
The board may discuss how long the effect of government stimulus measures taken around the world will last, which may affect the BOJ's own forecast of a gradual economic recovery from October through early next year.
That forecast, made in April, heavily depends on stimulus-driven demand and a rebound in overseas economies, particularly in the United States.
Despite growing optimism that the worst of the global recession has past, many BOJ officials remain cautious. They question whether overseas growth will be strong enough to provide lasting support to Japan's export-reliant economy. The debate is, however, at an early stage and the central bank is not yet expected to reach any conclusions.
MARKET IMPACT: Money markets may react in the highly unlikely event that Shirakawa suggests the recovery may be delayed. Any such remark would be taken as a signal that the BOJ will not end its unconventional policy measures in December, weighing on money market rates and bond yields.
UPGRADES ASSESSMENT
PROBABILITY: Low
The BOJ could give a more upbeat assessment on the economy to reflect recent rises in exports and output, but this is highly unlikely given the weakness in domestic final demand. The jobless rate has also hit a six-year high.
While it may consider saying the economy will "pick up" either in September or October, rather than "bottom out" as it says now, it will only do so if there are clear signs that the effect of government stimulus measures is broadening.
Such a change in wording would unlikely shake up financial markets much as it would not alter the dominant market view that the BOJ will keep interest rates very low for some years to come.
MARKET IMPACT: Any surprisingly upbeat comments could be taken by some market players as suggesting the BOJ will let its fund-support measures expire on schedule in December.
WARN OF DEFLATION SPIRAL, SIGNAL MORE EASING
PROBABILITY: Very low
A record annual fall in June consumer prices came as little surprise to many BOJ officials, who already expect price falls to accelerate in coming months due to declining energy costs and weak household demand.
The BOJ is already forecasting two years of deflation and some officials warn that price falls will persist even for another year. Several sources with direct influence over policy told Reuters that the central bank will probably forecast the period of deflation extending to March 2012 in its semi-annual report due in October.[ID:nT347265]
But they see little need to act unless Japan slips into a deflationary spiral, in which weakness in the economy and price falls feed into each other.
Shirakawa and his deputy, Hirohide Yamaguchi, have both said the risk of this happening is small since the economy is expected to gradually recover later this year. [ID:nT211178]
MARKET IMPACT: Money market rates and bond yields, especially at the short end of the curve, would plummet as markets currently are not pricing in any chance of further monetary easing. (Editing by Tomasz Janowski)