By Leika Kihara
TOKYO (Reuters) - The Bank of Japan upgraded its economic assessment on Friday, setting itself up for a confrontation with a government pressing for a policy response to deflation and a possible return to recession.
The Japanese government published a report that pronounced the economy officially in deflation for the first time since 2006, and a minister said he expected an "appropriate" policy response from the BOJ.
Having rebuffed government appeals to extend support for credit markets, the central bank may soon find itself under pressure to buy more government bonds as rising yields threaten an economic recovery, analysts said.
The central bank, having held its policy rate at 0.1 percent after a two-day policy review, appeared to suggest the ball was in the government's court.
"The cause of sustained price falls is a lack of demand," Governor Masaaki Shirakawa told a news conference.
The central bank was doing everything it could to provide liquidity to the economy including by keeping interest rates very low, he said.
"When demand itself is weak, prices won't rise just through liquidity provision," Shirakawa said.
That was an attempt to deflect government pressure to respond to falling prices, said Koji Ochiai, senior market economist at Mizuho Investors Securities.
"If share prices fall more or if the yen strengthens much more, the BOJ might be forced to take more steps," he said.
"It can either say explicitly that low interest rates will stay for an extended period, just like the Fed does, or it could increase its purchases of government bonds."
The BOJ buys 21.6 trillion yen (146.4 billion pounds) of Japanese government bonds each year.
Rising bond yields and the risk of a credit rating downgrade have hamstrung government efforts to stimulate the economy and avoid what it fears will be a second recession early next year.
Investor concerns about Japan's fiscal health helped widen the spread between two-year/10-year yield spread to a 3-1/2-year high of 121 basis points last week. Japan's sovereign five-year credit default spread widened to around 77 basis points early last week, its highest since April.
Finance Minister Hirohisa Fujii said on Friday rising bond yields could undermine government efforts to help small companies, flagging the same concern he and other government officials cited as they pressed the BOJ to extend its corporate debt buying beyond December.
"Monetary policy is absolutely vital. It is like the lifeblood of the economy, so I want the BOJ to respond appropriately," Fujii told a news conference.
The BOJ said it would maintain very easy monetary conditions.
It dropped a more specific pledge to keep interest rates at low levels for some time, a line it inserted into the statement when it announced it would scrap some support for credit markets last month.
While that line appeared to have been inserted to placate a worried government, the central bank's decision to upgrade its view on the economy on Friday was likely to provoke a strong response.
"Recent price developments show that the Japanese economy is in a mild deflationary phase," the government said in its report on the economy.
The report did not say how it wanted the central bank to tackle deflation. The OECD on Thursday urged the BOJ to keep interest rates low and buy more government bonds to help beat deflation.
Government officials have criticised the BOJ's view that the economy is starting to pick up as too rosy, arguing that the country could return to recession as job losses rise.
The BOJ also said it remains on guard against any risks to economic growth, particularly when the effect of domestic tax breaks tapers off early next year.
Two government representatives attend BOJ policy meetings. They cannot vote but they can request delays in policy decisions.
The BOJ is reluctant to buy more government bonds, arguing that there is not much room left to increase its bond buying with the balance of its government debt holdings already near a self-imposed ceiling.
(Editing by Hugh Lawson)
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