The governor of the Bank of Japan said the bank will act decisively in the event of renewed financial market turmoil, his strongest hint yet at fresh support for the economy that analysts say could involve buying more government bonds or a return to quantitative easing.

A government spokesman said quantitative easing will indeed be part of the talks when BOJ Governor Masaaki Shirakawa and Prime Minister Yukio Hatoyama meet this week, as the government leans on the central bank to act against deflation.

We absolutely don't have any plan to prepare for exiting our easy policy, Shirakawa told business leaders in Nagoya, central Japan.

We had some developments in financial markets last week. If we experience financial market turmoil again, the BOJ will act aggressively and decisively, he said.

Despite mounting pressure from the new government, which is worried about the risk of another recession, the BOJ has said there is little it can do beyond keeping interest rates at the current 0.1 percent to push up prices.

But analysts say the BOJ will eventually be pressed to increase its government bond buying or revert to a quantitative easing policy of flooding markets with extra cash.

It is likely the BOJ will do more. The most important measure is the BOJ's purchase of government bonds, said Simon Wong, a regional economist at Standard Chartered in Hong Kong.

The current path paves the way for the BOJ to further ease in terms of buying of JGBs, and the current inflation environment creates a perfect backdrop to expand monetary policy.

Shirakawa gave few clues on whether an increase in bond buying was an option, saying only that the bank will take the most appropriate decision based on economic developments at the time. The BOJ now buys 21.6 trillion yen ($250 billion) in long-term government bonds from the market each year.

The government has declared Japan to be in deflation and has criticized as too optimistic the BOJ's view that annual consumer price falls will gradually ease and that another recession is unlikely.

Hatoyama said the government needed to act decisively against deflation and the yen's surge, which hurts Japanese exporters by making their goods less competitive overseas.

We recognize that we need decisive steps to deal with recent economic conditions such as the yen's rise and mild deflation... We will compile economic measures soon, he told parliament.

In a bid to fend off speculation the two were at odds over economic policy, Shirakawa said the BOJ shared the government's view that the country was in mild deflation in the sense that price falls are likely to persist.

Shirakawa apparently tried to toe the government's line that monetary policy has a part to play in fighting deflation, said Hirokata Kusaba, senior economist at Mizuho Research Institute.

Still, what the BOJ can actually do to fight deflation is limited. It may increase its government bond buying but only within the scope of current BOJ rules.

The BOJ has said buying more bonds would be difficult as its government debt holdings are nearing its self-imposed ceiling.

INTERVENTION NOT RULED OUT

Hatoyama's government, only two months old and largely untested on fiscal policy, has adopted the kind of heavy-handed approach toward the BOJ that previous governments have used to influence monetary policy.

But it has been vague on exactly what it wants the BOJ to do.

Government bond yields fell to a seven-week low last week on speculation sharp yen gains may prompt the BOJ to loosen monetary policy further to support the economy. The benchmark 10-year yield bounced back to 1.260 percent on Monday.

The administration is considering including measures to ease the pain from the yen's rise to a 14-year high against the dollar in an extra stimulus package it plans to compile this week.

National Strategy Minister Naoto Kan said the government would try to slow the yen's rise, but he gave no specific details on how it would do it.

Shirakawa said he saw recent currency moves as unstable and that he recognized the pain felt by Japanese companies from the yen's surge, adding that currency volatility was undesirable.

Finance Minister Hirohisa Fujii left markets guessing on whether Tokyo would step into the currency market to stem further yen rises, warning on Monday that he had never said intervention was impossible.

The finance ministry has jurisdiction over currency policy, and the BOJ conducts currency intervention on the ministry's behalf.

Industrial output rose 0.5 percent in October and manufacturers forecast further rises in the following two months, data showed, easing some concern that the economy could slow to a standstill or even contract early next year.

But the yen's surge last week is hurting manufacturers' profitability and could derail an export-driven recovery.

For a graphic on output click http://r.reuters.com/dam93g

Voter support for Hatoyama's cabinet is above 60 percent but has slipped gradually. The nightmare scenario for the cabinet is an economic downturn ahead of an upper house election in mid-2010.

(Editing by Hugh Lawson)

Japan Inflation Bank of Japan Quantitative easing