By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) - Japan's government and central bank have agreed to set 2 percent inflation as a new target next week, when the Bank of Japan will also consider making an open-ended commitment to buy assets until the target is in sight, sources familiar with the BOJ's thinking told Reuters.
The central bank will also discuss at its policy review on Monday and Tuesday, scrapping interest it pays on banks' reserves, a move that will nudge money market rates to zero, according to the sources.
Faced with relentless pressure from Prime Minister Shinzo Abe to do more to pull Japan out of deflation, the BOJ is expected to double its inflation target and ease policy again at a two-day policy review that ends on Tuesday.
While the most likely option would be for the BOJ to top up its long-standing asset buying programme, central bankers will likely debate other measures such as open-ended asset purchases, to live up to market expectations for bolder monetary stimulus.
Any new initiatives would surprise investors, possibly putting the yen under more selling pressure and further boosting Japanese stocks, which have hit their highest levels in nearly three years on hopes of bolder policy measures.
The BOJ and the government are finalizing a joint statement they plan to issue on Tuesday, which would include 2 percent inflation as the bank's policy goal, deputy economics minister Yasutoshi Nishimura told Reuters.
"Governor (Masaaki) Shirakawa has been saying that 1 percent inflation would be in sight before long but we have not reached that stage yet," Nishimura said.
"If we share 2 percent inflation as a common objective, we expect the BOJ to do something very aggressive."
The statement will not set a specific deadline for achieving the target and leave the central bank freedom to decide on what steps to take to achieve it, Nishimura said.
But the government will examine how much progress the BOJ is making on achieving the target through its top economic panel, which the central bank governor attends regularly, a sign that pressure for bold monetary stimulus will persist.
MORE UNCONVENTIONAL STEPS
Abe, who led his Liberal Democratic Party to a landslide victory in a December 16 election with promises of aggressive budget and monetary stimulus, has suggested adding job creation to the BOJ's policy goals and making 2 percent inflation a medium-term goal that should be achieved in two to three years.
Both are problematic for central bankers, who argue that monetary policy alone cannot achieve those goals and are wary of committing to binding targets and deadlines.
Koichi Hamada, Abe's economic adviser and a vocal critic of the BOJ, kept up the pressure, saying the central bank should not set a deadline in expanding monetary stimulus as long as Japan remains in deflation.
Aware that investors have already priced in the new inflation target and another expected increase of 10 trillion yen ($112 billion) in the BOJ's asset buying and lending scheme - since October 2010 its main policy tool - central bankers are discussing other unconventional steps to maximize market impact, sources told Reuters.
One option would be to replace incremental increases in the asset programme with a U.S. Federal Reserve-style open-ended pledge to continue buying assets until the inflation goal is within reach, without setting a deadline for completing the purchases, the sources said.
Another idea would be to pledge to maintain the balance of the programme even beyond its end-2013 deadline, they said.
The BOJ will also consider scrapping the 0.1 percent interest paid on financial institutions' reserves held with the central bank, according to the sources, who spoke on condition of anonymity due to the sensitivity of the matter. That rate has effectively served as a floor to money market rates and kept them from falling to zero.
Such a proposal from BOJ board member Koji Ishida was voted down by 8-1 at the December meeting, but another board member, Sayuri Shirai, said in a recent speech that the idea was worth considering as a way to further push down interest rates and help further weaken the yen.
The new government's push for more public spending - it approved 10 trillion yen in extra spending last week - and aggressive easing has helped reverse the yen's gains, setting off stock market rally led by exporters and construction firms.
But many economists warn the stimulus may give the sluggish economy only a temporary jolt at best if Abe's government fails to follow through with politically more difficult economic reforms needed to lift Japan's long-term growth potential.
They also warn the push to reflate the economy long-trapped in sub-par growth could backfire if the new government's medium-term fiscal plan due in mid-2013 fails to convince markets that it can get Japan's ballooning debt back under control.
The yen's recent declines, driven by expectations of aggressive monetary easing, have drawn complaints from countries like Russia and Germany, worried about a destabilizing currency devaluation.
Shirakawa met with Finance Minister Taro Aso and Economics Minister Akira Amari on Friday to narrow their differences over the statement they aim to issue next week. The ministers are due to fine-tune the statement with Abe once he returns from a trip to Southeast Asia, according to a government source.
As politicians continue to pile pressure on the BOJ, IMF Managing Director Christine Lagarde warned against excessive government meddling in monetary policy.
"Monetary policy with a different inflation target is in and of itself certainly a good and interesting project if associated with clear independence of the central bank," she said.
($1 = 88.4950 Japanese yen)
(Additional reporting by Yoshifumi Takemoto, Sumio Ito, Stanley White, Kaori Kaneko and Yumi Muranaka in Tokyo, Lesley Wroughton in Washington; Writing by Tomasz Janowski and Leika Kihara; Editing by Kim Coghill/Simon Cameron-Moore)