The Bank of Japan kept monetary policy on hold on Tuesday but warned of weakening factory output and business sentiment, assuring markets that it was focusing on downside risks to growth that may trigger further easing ahead.

The decision to stand pat on policy was widely expected as the central bank likely felt no imminent need to top up its new asset buying scheme, with Tokyo stock prices on the rise and the yen well off a 15-year high hit against the dollar last month.

But with the outlook murky, BOJ policymakers are expected to have scrutinized various risks to the economy that may hurt business morale, which is seen worsening in the coming three months.

The BOJ kept its economic assessment unchanged but revised down its view on output, saying it had declined slightly. The bank also warned that business sentiment has been somewhat weak, signaling that it saw its latest tankan survey as offering negative signals for the economy.

Markets are on the lookout for what Governor Masaaki Shirakawa has to say about recent rises in Japanese bond yields, which add to the hardships facing the frail economy.

No change doesn't mean no message. The BOJ is saying they remain cautious despite the market being more optimistic. I think the BOJ is trying to calm the JGB market by saying recovery is still uncertain, said Takuji Okubo, chief economist at Societe Generale Securities.

The biggest uncertainty is in the United States. If the market decides that the Federal Reserve's quantitative easing is a mirage, the yen would rise and stocks would tank. That could prompt the BOJ to increase asset purchases, maybe to 7.5 or 10 trillion yen ($90-120 billion).

As widely expected, the BOJ kept interest rates at a range of 0 to 0.1 percent, joining other major central banks in supplying abundant funds to markets to support their economies.

RATE RISE HEADACHE

Recent rises in Japanese long-term interest rates have created a headache for the BOJ, which aims to push down one- to two-year yields with its new asset buying scheme.

The 10-year Japanese government bond yield hit a seven-month high of 1.295 percent earlier this month, tracking sharp gains in U.S. bond yields after President Barack Obama's deal to extend tax cuts boosted both expectations for U.S. economic growth and worries over a swelling U.S. deficit.

The benchmark JGB yield was at 1.180 percent on Tuesday, off that peak, but analysts say Japan's plan to issue a record amount of bonds to the market next fiscal year will keep investors worried about the country's dire finances.

The BOJ feels there is little it can do to curb the rise in Japanese yields, largely driven by gains in U.S. Treasury yields, and does not see a need for an immediate policy response.

Still, Shirakawa may try to calm markets at his post-meeting news conference by signaling that the BOJ is mindful of bond moves and will act if yields rise too much.

Any action would take the form of supplying funds more frequently through its market operations to keep money market rates stable, rather than an immediate shift in policy.

The BOJ eased policy in October by pledging to keep interest rates effectively at zero until the end of deflation was in sight and by crafting a 5 trillion yen fund to buy assets ranging from government bonds to corporate debt.

BOJ policymakers have repeatedly said that increasing the size of the fund would be a clear option if the looming economic slowdown proves worse than expected.

But the central bank does not want to expand the fund too soon since it finished rolling out the scheme only last week, when it began buying real estate investment trusts.

For now, the BOJ will focus on analyzing how markets have responded to its asset purchases. The outcome may affect future decisions on what kind of assets it should buy more of, if it were to top up its asset buying fund in the future.

Japan's economy is expected to contract slightly in the final quarter of this year on slowing overseas growth and slumping factory output, after the September expiry of government incentives for purchases of low-emission cars.

Improving prospects for the U.S. economy have yet to convince the BOJ that things are brightening up enough to divert from its easy policy bias, given the U.S. Federal Reserve itself is sticking to plans to buy $600 billion of bonds to support growth.

Analysts expect Japan's economic growth to pick up early next year with support from exports to fast-growing Asia, but only modestly, keeping the BOJ under pressure to maintain its easy monetary policy.

(Additional reporting by Rie Ishiguro; Editing by Edmund Klamann)

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