By Leika Kihara
TOKYO, Dec 17 (Reuters) - The Bank of Japan is expected to slash interest rates this week after the U.S. Federal Reserve's dramatic rate cut, but stop short of returning to a quantitative easing policy of flooding markets with massive amounts of cash.
The BOJ is seen cutting rates on Friday to just above zero, either 0.1 or 0.15 percent, a Reuters poll showed.
If the global recession deepens, the BOJ may return to quantitative easing early next year.
It would be the second bout of quantitative easing in Japan, which adopted the policy for five years from 2001, as it battled the after effects of a property and stock bubble burst.
At the time, Japanese banks were saddled with a huge pile of bad loans. That made them hesitant of lending to companies despite the massive injections of cash by the BOJ, making the policy less effective.
CHANCE OF RETURN
* A return to quantitive easing could be hard to swallow for BOJ Governor Masaaki Shirakawa who, as a central bank bureaucrat was involved in crafting the policy and has warned that keeping rates too low will distort market functions.
* But senior BOJ officials have said the bank was not ruling out any policy options as the economy, already in recession, faces the risk of suffering its longest contraction on record.
* Shirakawa told parliament on Tuesday quantitative easing had a certain effect in stabilising the financial system, adding that he was examining the effects and side-effects of the policy.
* Analysts say the BOJ could consider reverting to the ultra-easy policy next year if the global financial crisis pushes Japan deeper into recession and hurts its financial system.
MODIFIED VERSION?
* Even if quantitative easing becomes an option, it will likely take a different shape from last time.
* Last time, the BOJ said it would target the amount of cash in the economy, not interest rates, and said it would maintain quantitative easing until annual consumer inflation turned positive.
* Shirakawa, in his book published in March, said targeting money and flooding markets with excess cash might have helped the banking system but did little to boost the economy.
* Rather, stimulus came from the BOJ's commitment to stick to quantitative easing until consumer inflation emerged, Shirakawa said, a view widely shared by academics. That's because the commitment boosted market expectations that monetary conditions would remain easy for a long period of time, thereby keeping long-term interest rates low.
* Deputy Governor Hirohide Yamaguchi told parliament last month that the commitment, called the "policy duration effect," helped the economy.
* The Fed, in cutting U.S. rates to 0-0.25 percent on Tuesday address the same issue saying it expected exceptionally low rates for some time.
COMMITMENT
* The challenge would be to come up with a viable and credible commitment. With Japan no longer in deflation and consumer prices swayed much by energy costs, committing to a policy based on price moves might not work.
* The BOJ might end up with a broader commitment such as pledging to keep rates low for a "considerable period of time" or until the economy recovers.
* But such a vague commitment might not work as it would leave markets wondering how long the easy policy will last. The BOJ might also find it hard to exit the policy if the definition is not clear enough.
* "It's hard to come up with a single piece of data that would suit as a peg for policy when the fate of Japan's economy is so reliant on global developments," says Izuru Kato, chief economist at Totan Research.
* The BOJ has been hesitant of directly buying risky assets, out of fears of losing taxpayers' money. But that may change under quantitative easing as the BOJ tries to flood markets with cash by buying up large quantities of securities.
* Increasing the BOJ's monthly JGB purchase amount, from the current 1.2 trillion yen ($13.5 billion) per month, or reviving a scheme to buy asset-backed securities outright, adopted five years ago, could be among future options. ($1=88.99 Yen)