Taking financial markets by surprise, the Bank of Japan eased its monetary policy on Tuesday in what analysts said was a sign of concern about the potentially harmful impact on the economy of the recent strength of the yen.
The BoJ said after a two-day board meeting that it would raise its target volume for surplus funds in the banking system, as measured by banks' deposits held at the central bank, to 30-35 trillion yen ($280-326 billion) from 27-32 trillion.
The move surprised the markets as recent indicators have suggested Japan's export-led economy continues its recovery from a decade of stagnation.
"It's difficult to explain why they had to do this, but I suppose it is aimed at countering the deflationary impact of a higher yen," said Masahiko Nishida, a senior economist at Mizuho Research Institute.
The BoJ said moves in the financial and currency markets and their impact on the economy needed close monitoring - a likely reference to the yen's recent strength.
"When taking into account how markets, mainly the foreign exchange market, affect people's sentiment, I feel (the strong yen) could become a downside risk," BoJ Governor Toshihiko Fukui told a news conference.
A higher yen reduces import prices in yen terms and has a deflationary effect on the economy.
In its official statement the bank said the further easing was meant to reaffirm its policy stance on overcoming deflation and ensuring a continued recovery.
Under its "quantitative easing" policy, the BoJ sets a target range for the current account reserves that banks hold at the central bank in the hope that the funds will be lent to companies and households to spark economic activity.
So far, the policy has had limited success - bank lending in Japan has fallen on a year-on-year basis for the past 72 months.
Mamoru Yamazaki, chief economist at Barclays Capital, said the decision to ease further may also have a political tinge.
"It will also show that the BoJ is doing something, especially before the G7 meeting next month," he said. The Group of Seven economic powers meet in Florida on February 6-7.
In a separate report, the central bank said the economy was on the mend but the pace of recovery was being tempered by structural problems such as corporate debt and deflation, now in its fifth year.
It kept its assessment of the economy unchanged from the previous month, reiterating that "Japan's economy is recovering gradually." It also maintained its view that deflation would continue to be a problem for some time yet.
The government upgraded its reading of economic conditions on Monday, saying exports were lifting output and capital spending and even filtering through to chronically weak consumption.
But the strength of the yen was a common theme in both reports, and Japanese officials have stepped up rhetoric over the yen's rise, which they see as denting exporters' profits.
A recent survey by the Ministry of Economy, Trade and Industry showed companies felt that a dollar rate of 100-105 yen would be a serious problem.
The yen, which was trading at around 107.50 to the dollar before the BoJ announcement, retreated to 107.62 after the policy decision before rising to 107.16 in late trade.
The Japanese currency had recently been trading near three-year highs of 105.70 yen to the dollar.
Japan spent about 20 trillion yen ($188 billion) last year to rein in the yen and traders said authorities likely intervened again recently after the yen jumped to three-year highs.
Economists said another reason for the easing may have been a technical one due to the massive amounts of intervention.
"I think the decision was prompted by the strong yen and there were two main factors - its impact on the economy, and the difficulty of money market operations caused by massive amounts of yen-selling intervention," said Kiichi Murashima, economic and market analysis director at Nikko Citigroup.
The move, which was widely expected, is aimed at allowing banks to offset risks in lending to small and medium-sized companies, but the effort has yet to make an impact on money flows in the absence of a mature securitisation market in Japan.
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