A Bank of Japan policymaker signaled on Wednesday the central bank was open to adopting more measures to support the economy following its emergency meeting the previous day that offered extra short-term funding.

The Bank's governor Masaaki Shirakawa said Prime Minister Yukio Hatoyama did not ask him to take additional easing steps when the two met, adding that they shared the same view on deflation.

The BOJ has come under fire from the government to do more to support the economy and avert the risk of another recession ahead of elections next year for parliament's upper house. The BOJ emergency decision on Tuesday to provide short-term funding was seen as a way to relieve that pressure.

Hatoyama, speaking to reporters after the meeting, steered clear of criticizing the BOJ, saying the government and the central bank will work together to end deflation.

But outspoken BOJ critic Shizuki Kamei, the banking minister, was on the offensive earlier, saying he was deeply unhappy with the outcome of the BOJ's meeting.

The BOJ was sleeping. It woke up a little bit and is still sleepy-headed, said Kamei, the head of a tiny coalition ally who has often attacked the central bank.

Markets also reacted with disappointment on Tuesday and government bonds continued to fall on Wednesday. Investors had been primed for more BOJ bond buying or a return to full quantitative easing -- a policy of flooding banks with cash to stimulate lending -- when the central bank called the meeting.

Instead, the BOJ offered 10 trillion yen ($115 billion) in three-month funds at 0.1 percent, which analysts said might help check a yen rally but would do little to tackle deflation.

Suda said the central bank was open to any policy options if the economy was to undershoot its forecasts, a bone of contention with the government, which considers them to be too optimistic.

The costs and the benefits (of any policy options) can change depending on the situation in financial markets. We are always open to what the best policy measures are, she said in a speech to business leaders in central Japan.

FURTHER EASING EXPECTED

Shirakawa defended the BOJ's decision on Tuesday by saying it constituted a form of quantitative easing, but analysts said the BOJ may have to do more.

We could expect further easing sometime in the future, say by the end of the fiscal year, said Satoru Ogasawara, an economist at Credit Suisse in Tokyo.

The BOJ's new market operation may help financing toward the year-end, but it may be difficult to push up the economy and inflation expectations.

While the United States and Europe are expected to face pressure for prices to fall in the year ahead as the global recovery proves mild, Japan is mired in deflation.

That was reflected in a Reuters survey released on Wednesday.

The monthly Reuters tankan survey showed manufacturing sentiment rose in November to levels not seen since October 2008, but the mood among companies remained negative, suggesting deflation would drag on the pace of recovery.

Deflation, or persistently falling prices, can dampen economic activity as buyers put spending on hold to wait for yet lower prices.

The Reuters survey, which is closely correlated with the central bank's quarterly tankan survey, showed that sliding prices hurt service industry sentiment, partly because of a loss of pricing power in the face of bleak job and income conditions.

The world's No.2 economy grew at its fastest pace in two years in the third quarter thanks to stimulus spending around the world, but deflation, a yen rally to a 14-year high against the dollar and tumbling share prices are clouding the outlook.

That is why Hatoyama's Democratic Party, swept to power in an August election, fears Japan could slip back into recession in early 2010 after having just emerged this year from its worst economic contraction on record.

Such a scenario makes party leaders fearful of a backlash at the ballot box when upper house elections are held in mid-2010.

One BOJ policy option would be to buy more government bonds to inject more cash into the economy. But Suda suggested this could raise doubts about the government's fiscal discipline to reduce the highest public debt among G7 countries, resulting in higher long-term interest rates.

Finance Minister Hirohisa Fujii said moves in long-term bond yields reflect the government's commitment to maintain the trust of the bond market with fiscal discipline.

FOREX SWINGS ADD TO WOES

Suda, who is seen as holding hawkish views on monetary policy, acknowledged that inflation expectations could fall as a rapid yen rise hurts the real economy in the near term. But she maintained that the risk of a deflation spiral was not rising and the economy overall was moving in line with BOJ forecasts.

The former economics professor said Japan's real GDP may shrink temporarily as the effects of stimulus spending wane.

Annual core deflation, which hit 2.2 percent in the year to October, would be around 1 percent by the end of this year and the pace of narrowing would moderate thereafter, she said.

For its part, the government is expected to prepare an economic stimulus package this week which Japanese media reported would include new spending of 4 trillion yen ($46 billion), much bigger than the government's earlier projection of about 2.7 trillion yen.

The BOJ is unlikely to announce further policy steps at its next scheduled meeting on December 18, but a poor reading in its quarterly survey of business sentiment on December 14 could add to pressure for more monetary easing.

The monthly Reuters Tankan is designed to be a leading indicator for the BOJ tankan, with a 95 percent correlation.

For graphic on the Reuters and BOJ surveys, click on:

http://graphics.thomsonreuters.com/129/JP_RTKN1209.gif

($1=87.04 Yen)

(Editing by Michael Watson)

Japan Credit Suisse Inflation Quantitative easing