By Leika Kihara
TOKYO (Reuters) - The Bank of Japan is expected to keep monetary settings unchanged on Friday even as weakening manufacturing activity in Asia continues to cloud the outlook, preferring to spend some time reviewing the effect of its policy loosening last month.
This week's meeting will precede a more important rate review on October 30, when the BOJ is likely to cut its long-term economic and price forecasts, and acknowledge that Japan remains years away from achieving the bank's 1 percent inflation target.
That will keep the central bank under pressure to offer further stimulus, despite boosting asset purchases just last month as sagging exports to China and Europe delay a recovery in the world's third-largest economy.
The BOJ is expected to hold off on expanding asset purchases this week, but analysts see a good chance it may consider easing again on October 30.
"The economy is worsening and won't pick up until early next year," said Yoshiki Shinke, senior economist at Dai-ichi Life Research Institute in Tokyo.
"The BOJ would have to cut its growth forecasts later this month and alter its view that Japan will achieve 1 percent inflation in fiscal 2014. If that's the case, it makes sense to ease policy again," he said.
Japan's economy has so far outperformed most of its peers in the Group of Seven on spending for rebuilding from last year's earthquake and tsunami. But with that effect fading, domestic demand may not make up for falling exports for too long.
Worried that the recovery may be stalling, the BOJ eased policy last month by boosting its asset buying and loan program by 10 trillion yen to 80 trillion yen ($1 trillion).
But data released since then has continued to disappoint.
Factory output fell to a 15-month low in August on sagging sales in its top export market China and business sentiment soured in the three months to September, fuelling concerns that the world's third-largest economy could slip into recession.
Manufacturing contracted in September for a fourth straight months, but at a slower pace than in August, in a tentative sign that weak overseas demand may be stabilizing.
One of the BOJ's policymakers, Takehiro Sato, told Reuters that the BOJ was ready to act again should the economy underperform despite this month's stimulus.
RUNNING OUT OF TOOLS
At Friday's meeting, the nine-member board is seen debating risks to the outlook, such as how anti-Japan protests in China over a territorial row could affect trade between the nations and corporate business plans.
Central bank policymakers may also discuss how a delay in Japan's economic recovery could affect the timing of achieving the BOJ's 1 percent inflation target set in February.
The BOJ now projects core consumer inflation of 0.2 percent for the current business year ending in March 2013, and 0.7 percent in the following year. It has also said Japan will achieve 1 percent inflation around fiscal 2014.
That is far more optimistic than the view of analysts, which project core consumer inflation of just 0.2 percent in fiscal 2013, according to a Reuters poll. Many expect deflation, which has plagued Japan for more than a decade, could persist well into 2014.
The stubbornly strong yen also weighs on the export-reliant economy. While off the record 75.31 to the dollar set last year, the yen remains above the average 79.06 forecast by big Japanese manufacturers for the current business year. The dollar stood at 78.12 yen on Tuesday.
Reflecting weakness in the economy, the central bank is expected to cut the forecasts on October 30 and signal a delay in achieving 1 percent inflation, sources familiar with its thinking say.
But the BOJ is running out of tools to force-feed cash to markets already awash with excess funds.
It needs to pump 20 trillion yen more into markets by the end of next year to achieve the 80-trillion-yen ($1 trillion)target set for its asset buying and loan program, under which it offers funds via market operations and buys government bonds, corporate debt and trust funds investing in stocks and property.
That is no easy task because commercial banks, struggling to find companies willing to borrow money amid a weakening economy, are in little need of cash and so are piling up the money into their deposits at the central bank.
Some market players want the BOJ to boost purchases of risky assets, such as exchange-traded funds (ETF), to help lift stock market sentiment. But the BOJ sees little room to do so for fear of exposing its balance sheet to too much risk.
The BOJ is also wary of setting its policy rate to zero, instead of the current range of zero to 0.1 percent, as doing so would discourage commercial banks from lending to each other.
That means the most likely path would be for the central bank to continue boosting government bond purchases, the sources have said, adding that there is still room to pledge bigger amounts of bond purchases for next year.
For now, however, the BOJ is hesitant of going down the U.S. Federal Reserve's route of committing to an open-ended asset buying program as doing so could make an exit from ultra-easy policy difficult.
($1 = 78.0600 Japanese yen)
(Editing by Kim Coghill)