Standard and Poor's on Tuesday threatened to cut Japan's rating unless it produced a credible plan to rein in its soaring debt and lift growth in an economy plagued by persistent deflation.

The warning in the form of a downgrade in Japan's debt outlook coincided with the Bank of Japan's policy meeting at which it forecast price declines would be less pronounced than earlier thought.

Still, faced with renewed calls from the government to do more to support a fragile economic recovery, the central bank signaled it was open to relaxing its loose policy even further.

Japanese policymakers, however, are in a tight spot, with public debt heading toward 200 percent of gross domestic product -- the highest among developed economies -- interest rates near zero and the central bank's several emergency funding schemes still in place.

S&P, which cut its outlook on Japan's long-term sovereign debt rating to negative from stable, highlighted the shrinking room for policy maneuver and persisting price declines that threaten economic recovery as the main reasons for its warning.

The outlook change reflects our view that the Japanese government's diminishing economic policy flexibility may lead to a downgrade unless measures can be taken to stem fiscal and deflationary pressures, the agency said in a statement.

Moreover, the policies of the new Democratic Party of Japan (DPJ) government point to a slower pace of fiscal consolidation than we had previously expected.

The government took office in September.

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Agost Bernard, associate director for sovereign ratings at S&P, said in a conference call that the rating could change any time within the two-year horizon of the new outlook.

The outlook cut follows similar warnings from Moody's and Fitch that their ratings hinged on Tokyo's efforts to get government finances under control.

The yen and Japanese bond futures dipped after the announcement, but analysts said even ratings cuts would have limited market impact given Japan's reliance on the vast pool of domestic household savings for its borrowing. The savings are estimated at $16 trillion.

There have been repeated (credit downgrades) in the past 10 years, and the past record shows they won't have much impact on financial markets, said Naoki Murakami, chief economist at Monex Securities in Tokyo. Japan is running a current account surplus now and is not relying much on foreign investors.

S&P said Japan's position as the world's largest net creditor, the yen's status as a reserve currency, a diversified economy and a resilient financial system all supported the country's ratings and mitigated the debt pressures.

Yet the warnings come at the worst possible time for the four-month old government of Prime Minister Yukio Hatoyama, struggling with a funding scandal and facing pressure to deliver on its campaign promises ahead of mid-year upper house polls.

Hatoyama needs a resounding win in the elections to avoid a policy deadlock that the struggling economy can ill afford.

Feeling the heat, his ministers have been piling pressure on the Bank of Japan to go beyond steps taken so far to support the economy.

If new action is needed, options being floated in the central bank include boosting its purchases of government debt or expanding a low-cost bank funding scheme announced at an emergency meeting last month.

S&P said its final ratings verdict would largely depend on upcoming economic data and how the government proposes to ensure sustained growth and prevent debt from getting out of control.

The ratings on Japan could fall by one notch if economic data remain weak and measures to boost medium-term growth are not forthcoming, given the country's high government debt burden and its weak demographic profile, it said.

Standard & Poor's will be looking for signs of government policy toward fiscal consolidation in the update of its medium-term fiscal plan, due to be released in the first half of 2010, the agency added.

(Writing by Tomasz Janowski; Editing by Neil Fullick)

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