The policy deadlock in Japan resulting from the ruling party's drubbing in upper house elections raises obvious concerns for Prime Minister Naoto Kan.

But the Bank of Japan should be worried too.

The government is likely to turn to the central bank to ease its already super-loose monetary policy further should the economic recovery face any risks and so threaten to add to deflation, which has been at the heart of the economy's sluggish performance for years.

A failure to sell a proposal to Japanese voters to double the country's sales tax was blamed by Kan for the election result, so politicians will be reluctant to push fiscal reform despite the country's massive debt problems.

On top of that, Kan's Democratic Party of Japan will now be reliant on several smaller parties to push policies that may require compromise, or just lead to gridlock in policy making.

The Democrats won't be able to do much in terms of economic policy, so pressure on the BOJ to do more for the economy will heighten significantly, said Koichi Haji, chief economist at NLI Research Institute.

The DPJ won 44 seats in the election, far short of Kan's 54 target. The stinging rebuke deprives the DPJ and its tiny ally of the dominance needed to push their fiscal and economic policies smoothly through parliament.

The Democrats may rule the more powerful lower house, but without an upper house majority as well they face policy gridlock as a number of small and potential king makers push their agendas in exchange for their support.

PARTNERS

To be sure, even before the election, markets had speculated the government might pressure the BOJ to ease policy once again if the yen keeps climbing to threaten Japan's all important exports.

But the government will now struggle to push a fiscal reform agenda and will find it difficult or impossible to provide any fiscal support for the economy, making pressure on the central bank more likely.

Following the election, the Democrats have opted to enter alliances with smaller parties on a policy-by-policy basis, rather than trying to form a coalition.

Some opposition parties back some of the DPJ's fiscal policies, such as raising the sales tax -- long seen as a way to whittle down the country's public debt, which is double the size of the $5 trillion economy.

But they are cool to the notion of joining hands with the Democrats to help pass bills.

On the other hand, there is far less disagreement on the need for Japan to overcome deflation with easy monetary policy.

Major opposition parties like the Liberal Democratic Party and Your Party seem very eager to pursue monetary easing to beat deflation, said Hiromichi Shirakawa, chief Japan economist at Credit Suisse. I think the BOJ was the one most alarmed by the Democrat's big defeat.

One small party, the Your Party, is touted by analysts as among the most likely of alliance partners for the Democrats.

They expect it to push a more extreme view on the BOJ's role compared with the ruling Democratic Party, another sign of trouble for the central bank that has argued it has done enough to pull Japan out of deflation.

Most small parties, including the pro-reform Your Party, have called on the BOJ to set an inflation target to pull Japan out of deflation. Such a target would be more binding than the BOJ's existing practise whereby it says 1 percent inflation as ideal for price stability.

INFLATION TARGET

Kan has floated the idea of an inflation target. He has repeatedly said inflation at or slightly above 1 percent would be desirable for the economy, although that is a reach for a country that is seen mired in deflation at least until early 2012.

As finance minister, Kan pressured the BOJ to do more to beat deflation when the yen shot up to a 14-year high of 84.82 per dollar last November.

With its policy rate already at just 0.1 percent, that led the BOJ to loosen policy by putting in place a new cheap-loan programme in December. It expanded the scheme in March.

Your Party wants to push the BOJ further, pledging to revise the BOJ Law that guarantees central bank independence.

Party head Yoshimi Watanabe told Reuters on Monday he wants the BOJ Law revised so it is similar to laws governing the U.S. Federal Reserve by adding the need to seek maximum employment. [ID:nTOE66B048]

Your Party has won enough seats to submit legislation to parliament on its own. Analysts doubt the bill will garner enough support to pass through the Diet, but the proposals are still a headache for the central bank.

Your Party's calls for a bill to pull Japan out of deflation resonates with views held by some in Kan's own party, said Takeshi Minami, chief economist at Norinchukin Research Institute.

It probably won't go as far as a BOJ Law revision. But the views could influence government policy. The bank undoubtedly will come under consistent pressure for further easing.

Much will depend on how the economy recovers from the global downturn. It grew at an annualised rate of 5.0 percent in the first quarter, the second fastest among G7 economies after Canada.

Many analysts say the BOJ may ease policy again if it sees any threat to its forecast for the economy to recover moderately on the back of solid exports to Asia.

So far that has not been the case. But growth may slow later this year as a firmer yen undermines exports and the effect of government stimulus measures fades.

BOJ officials are also cautious because of signs of a potential slowdown in global growth following the euro area debt crisis and data showing the U.S. recovery is faltering.

The BOJ is independent by law but the government wields influence over monetary policy because it picks candidates when vacancies arise on the BOJ board, including that of the governor, and two government representatives sit in on policy meetings. (Additional reporting by Izumi Nakagawa, Kaori Kaneko; Editing by Neil Fullick)

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