The Bank of Japan hopes to avoid having to dig into its depleted policy arsenal next week, but may ease monetary policy if the yen soars toward an all-time high against the dollar and threatens a fragile economic recovery.

As long as the yen's climb is spread over several weeks or months, the central bank is expected to stand pat on policy with solid exports to Asia underpinning Japan's export-driven growth.

But the BOJ is ready to act if expectations of further monetary easing by the Federal Reserve drive down the dollar/yen rate fast enough to damage Japanese business sentiment. For example, a single day drop of 2-3 yen in the dollar/yen exchange rate could make the central bank nervous, traders said.

Still, it would probably settle for a minor tweak of policy rather than a radical change such as a return to full-blown quantitative easing. The effect on the yen and the economy would therefore be limited, analysts say.

Here are possible outcomes of the rate review:

NO CHANGE IN MONETARY POLICY

Probability: Highly likely

BOJ policymakers are becoming increasingly worried about the U.S. growth outlook and the potential negative impact of a strong yen on exports.

But for now, the central bank still forecasts a moderate economic recovery in Japan and sees little need to act as long as the yen's rise is gradual, giving businesses time to adjust.

With interest rates already near zero, many board members feel there is very little the BOJ can still do help the economy.

Market reaction: The yen may rise against the dollar, particularly if there is a build-up in expectations of further Fed easing at its policy meeting, due hours after the BOJ's policy announcement.

EASE POLICY WITH MINOR STEPS

Probability: Likely

The BOJ does not care much about yen levels but worries that if the dollar falls below a 15-year low of 84.82 yen, option triggers could accelerate its slide and push it toward an all-time low below 80 yen. It hit an eight-month low of 85.32 yen on Wednesday.

Some BOJ officials fear that dollar/yen declines may reach an alarming pace if Friday's U.S. payrolls data for July are weak and bolster expectations of further Fed easing.

During the Dubai debt crisis in November 2009 the dollar lost 4 yen in four days and fell 2 yen on November 27 when it hit the low of 84.82. The BOJ acted shortly afterwards, introducing its new loan supply scheme.

Sharp yen gains could push down stocks, hurt business morale and cast doubt on the outlook for a moderate recovery, prompting the central bank to seriously consider easing policy.

Analysts say the most likely step would be the expansion of the BOJ's scheme that funnels up to 20 trillion yen ($231.7 billion) in three-month loans to banks at 0.1 percent interest. By increasing the amount or extending the duration of the loans to six months the central bank could push down interbank lending rates and weaken the yen, they say.

But skeptics within the central bank argue that money market rates play a lesser role for the yen than they did last December when the loan scheme got introduced, with investors now focusing less on short-term rate differentials and viewing the yen more as a safe haven.

Another option would be to make a formal commitment to relaxed monetary policy, for example by pledging to keep rates low until deflation is comfortably overcome.

Still another possibility is for the BOJ to say it will allow the overnight call rate to slide below the target until markets stabilize. That would allow the central bank to flood markets with cash without changing the official overnight call rate target of 0.1 percent.

Such steps, however, would be unlikely to have a lasting impact on the yen or the economy, and would be seen as symbolic gestures meant to show the BOJ's determination to protect the economy from adverse market moves.

Market reaction: Money market rates and two-year bond yields, most sensitive to monetary policy, might briefly fall, subsequently pushing down the yen. But the impact would probably be short-lived.

REVERT TO QUANTITATIVE EASING, ZERO RATES

Probability: Highly unlikely

With the economy slowly recovering, the BOJ is unlikely to do anything radical unless Japan is hit by a financial shock on the scale of the crisis triggered by the collapse of Lehman Brothers in 2008.

Buying private assets, such as corporate bonds and commercial paper, makes little sense as companies do not have difficulty now in raising cash in these markets.

A return to old-style quantitative easing, which targets liquidity instead of interest rates, is being ruled out because the BOJ believes the last time it tried it early this decade it did little to boost the economy or defeat deflation.

Cutting the policy rate to zero from 0.1 percent is also frowned upon as it would deter banks from trading in the money market and make it hard for the BOJ to guide short-term rates.

The BOJ might consider increasing its government bond purchases, although doing so would be hard as its debt holdings are nearing a self-imposed cap.

Market reaction: The shift would come as a surprise and sharply push down money market rates, bond yields and the yen.

(Editing by Tomasz Janowski)

Japan Bank of Japan