By Leika Kihara and Rie Ishiguro
TOKYO (Reuters) - The Bank of Japan on Tuesday pledged to pump more funds into the struggling economy and keep interest rates virtually at zero, surprising markets and stealing a march on the Federal Reserve in providing a fresh dose of economic stimulus.
For months, the central bank had eschewed government calls for more decisive action, such as buying more government bonds, focusing instead on a limited funding scheme.
But in the face of growing evidence that the yen's strength was hurting the economy, the Bank of Japan cut its overnight rate target to a range between zero and 0.1 percent, from 0.1 percent, reinstating the so-called zero-interest policy that the bank ended in July 2006, and pledged to buy 5 trillion yen ($60 billion) worth of assets.
It also said it would keep its benchmark rate effectively at zero until price stability is in sight, adopting a U.S. Federal Reserve-style commitment to ultra-loose policy. Core consumer prices have been falling from year-earlier levels since early 2009.
"I would like to describe today's measures as a comprehensive monetary easing," BOJ Governor Masaaki Shirakawa told a news conference, adding that the steps have both the elements of credit easing and an expansion of fund supply.
"The latest measures individually may be considered as not having a major effect, but we want to maximize the effect by implementing the steps as a package."
The asset purchases would roughly match the size of extra stimulus being considered by Prime Minister Naoto Kan's cabinet.
The assets, ranging from government bonds and short-term government securities to commercial paper and corporate bonds, would come under a temporary scheme that would also cover 30 trillion yen of such assets as collateral under an existing loan programme.
"The BOJ is bringing its monetary policy closer to quantitative easing, allowing market rates to hover near zero and pledging to keep a near-zero interest rate policy in the longer term until prices stabilize," said Naomi Hasegawa, senior fixed-income strategist at Mitsubishi UFJ Morgan Stanley Securities.
BOJ policymakers have signaled in past weeks that they were considering a further easing of policy, after Tokyo's intervention in the currency market in mid-September to check the yen's strength offered only temporary relief.
Most market players, however, had expected the central bank to opt for a relatively minor adjustment of its 30 trillion yen loan scheme that supplies banks with funds at its 0.1 percent rate.
"These steps are more aggressive than markets had expected. The BOJ's decision is a surprise and will have an impact on currencies due to the message it delivers," Hasegawa said.
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The surprise move weakened the yen against the dollar, pushed up Japanese government bond futures and helped stock prices turn positive. <.N225>
The decision to cut interest rates was made by a unanimous vote, but board member Miyako Suda opposed the inclusion of government bonds among the types of assets the BOJ could buy using its pool of funds.
The BOJ is not the only central bank under pressure to do more to support an economy that is showing signs of faltering.
Financial markets expect the Fed to embark upon another round of asset buying to bolster a sluggish recovery as early as its November meeting. There are also calls within the Bank of England for further easing, although the bank has kept markets guessing on whether it will indeed do so.
In Japan, slowing export growth, a surprise fall in factory output and companies' worries that the strong yen may hurt the outlook have heightened the case for the central bank to ease policy.
The BOJ had already been edging nearer to quantitative easing by allowing the yen pumped into markets through currency intervention to remain in the financial system, instead of draining it.
($1=83.45 Yen)
(Writing by Tomasz Janowski; Editing by Neil Fullick and Edmund Klamann)
