* Pressure mounts on BOJ to ease policy next week
* PM, finance minister say ready to act if yen moves sharp
* But they emphasise markets should set FX rates
* BOJ to double 3-mth funding in policy review - report
* Yen may be real target of BOJ easing - analysts
By Leika Kihara
TOKYO, March 12 (Reuters) - Japan"s prime minister said thegovernment and the Bank of Japan should work together to beatdeflation as he fended off mounting political pressure for actionon the economy and the yen, raising expectations that the centralbank will ease monetary policy next week.
The prime minister, finance minister and central bankgovernor were grilled by lawmakers on Friday on what they intendto do to defeat deflation and prevent yen strength from harmingan economy struggling to recover from the global downturn.
Although the economy is growing slowly, weak domestic demandis contributing to deflation, which many policymakers fear couldpush Japan back into a damaging downturn ahead of upper houseelections expected in July.
The yen rose last week to a three-month high against thedollar and speculators are gearing up for a yen rally, raisingconcerns that exports could take a hit and deflation deepen.
Both Prime Minister Yukio Hatoyama and Finance Minister NaotoKan said the government was ready to act if the yen movedexcessively.
But their comments were seen as adding pressure on thecentral bank to ease policy further, rather than as a call forcurrency intervention that would set the government up for apotentially costly fight with financial markets and put Japan atodds with G7 efforts to promote market-based exchange rates.
"The comments from the government and the central bankgovernor lift market expectations that there will be some kind ofeasing steps by the BOJ next week," said Hideki Hayashi, globaleconomist at Mizuho Securities in Tokyo.
"It is the market consensus that Japan interventing solo inthe market won"t be effective, so the government will have todepend on the BOJ"s further easing policy," said Hayashi.
"The BOJ"s expected loosening of policy will push down yeninterest rates further, thereby supporting dollar/yen at the 90yen level," he said.
Sources told Reuters this week that the central bank wasconsidering expanding a three-month lending facility itintroduced in December following an emergency meeting, either byextending the period or increasing the pool of funds available.
But they also said board members were split, with someworried a further easing in policy was not economicallyjustified, especially as the economy was developing along thelines of the central bank"s official expectations.
"The decision will be made based on discussions among theseven board members," BOJ Governor Masaaki Shirakawa told theupper house budget committee, referring to those on the centralbank"s policy setting board.
"We hope to discuss what we can do in light of the goalsstipulated in the BOJ Law," he said.
The Nikkei newspaper said the BOJ would double its 10trillion yen ($110.4 billion) in funds offered under the lendingoperation at a policy review on Tuesday and Wednesday.[ID:nSGE62A0J4]
IS YEN REAL TARGET OF POLICY TIGHTENING?
Neither the BOJ nor the government have made an explicit linkbetween central bank efforts to loosen policy and the foreignexchange market.
But the strength of the yen against the dollar during theglobal downturn prompted complaints from industry that thecurrency"s level was harming their export prospects.
With the government"s ability to support the economy shackledby a debt load approaching 200 percent of GDP and the centralbank"s interest rates already at rock-bottom levels, someanalysts argue that reducing the yen"s strength may be the realtarget of policy loosening.
The December policy easing helped pull the yen JPY= backfrom a 14-year high of 84.82 per dollar, raising marketspeculation that the currency could be a factor in BOJ thinkingnow.
The yen rose last week to a three-month high and market datashows speculators are building long positions in the currency. Itwas trading around 90 per dollar on Friday.
In answer to lawmaker concerns over the currency, FinanceMinister Naoto Kan underlined that sharp yen moves were notdesirable by saying that authorities could use currencyintervention if foreign exchange movements were excessive.
However, he emphasised that markets should set currencyrates.
"Basically it"s desirable for currency rates to move stably,"Kan said. "I"m aware that the government has the option ofintervention when currency moves are rapid. But as long ascurrency moves are stable, it"s basically up to the market todetermine (levels)."
Shirakawa said the central bank"s loose policy was helping tocurb the yen"s strength, while Prime Minister Yukio Hatoyama alsosaid steps could be taken.
"Foreign exchange should basically be determinedappropriately by the market," he said.
"But there was the sovereign debt risk, the Dubai shock andthe Lehman shock ... There seem to be yen rises that don"treflect the strength of the Japanese economy and industry," hesaid.
"Against such yen rises, we need to take resolute action ...Although we can"t return to a fixed rate system, there needs tobe global cooperation on this front."
Analysts said his comments didn"t suggest any action wasplanned or imminent, but rather that he was playing to hisdomestic political audience.
Japan authorities have not intervened in markets sincespending 35 trillion yen over a 15 month period up to March 2004. ($1=90.59 Yen) (Additional reporting by Tetsushi Kajimoto; Writing by NeilFullick; Editing by Hugh Lawson)
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