NAGOYA, Japan (MNI) - Bank of Japan Governor Masaaki Shirakawa said on Monday that the BOJ will continue fighting deflation by keeping interest rates very low and supplying banks with ample cash so they can lend one another and make loans to needy firms.

In a speech to business leaders in Nagoya City, central Japan, Shirakawa said, "The bank will do its utmost to overcome deflation both in terms of monetary easing and ensuring the stability of the financial markets."

He also said that the BOJ shares the view on continued price drops with the government, which noted earlier this month that Japan is back in mild deflation. Until recently the country coped with several years of stubborn deflation since 2001, which was aggravated by large bad loans at major banks at the time.

"It is also important to avoid a situation in which the decline in prices induces adverse effects on economic activity, which in turn leads to a further decline in prices, namely, a vicious circle between economic activity and prices," said Shirakawa.

However, the governor didn't say what monetary policy action the BOJ may or may not take to fend off a deflationary spiral.

Sustained price declines threaten to squeeze profits and wages, dampening demand in an economy that is recovering only gradually from the global recession and is expected to slow down next year when the effects of the current fiscal stimulus fade.

At its last policy-setting meeting, the BOJ's board voted unanimously to leave the target for the overnight lending rate among commercial banks unchanged at a very low 0.1%, vowing to maintain "extremely accommodative" financial conditions to support the economy.

The BOJ board revised up its overall assessment of the economy for November from the previous month, saying, "Japan's economy is picking up mainly due to various policy measures taken at home and abroad."

But it also warned that "the momentum of self-sustaining recovery in domestic private demand remains weak," echoing the government's latest view that the economy lacks "autonomous" growth factors.

In today's speech, Shirakawa said that "steady efforts on the part of the policy authorities as well as the private economic entities are necessary for coping with the issue of deflation, and such a process necessarily takes some time."

He added that "a valuable lessons in history is that it is critical to ensure the stability of the financial system in preventing a vicious circle between the economy and prices."

"At the root of a continued decline in prices, there is a fundamental factor that demand is weak compared with the supply capacity of the economy as a whole."

"The bank has been doing its utmost as a central bank to meet the challenges of getting out of the state of continued decline of prices, namely deflation, and put Japan's economy back to a sustainable growth path with price stability, and made it clear to continue with such stance," said Shirakawa.

Earlier this month, the Japanese government left its overall assessment of the economy unchanged for the fourth straight month, repeating it is "picking up," with capex leveling off now, but warned of the damper of job cuts and deflation.

The Cabinet Office mentioned "deflation" in its monthly report for the first time in about three years since June 2006, although it was not highlighted in the overall assessment but listed at the bottom of bullet points outlining how different segments of the economy are doing.

"Recent price developments show that the Japanese economy is in a mild deflationary phase," it said.

Prime Minister Yukio Hatoyama and Shirakawa plan to meet sometime this week to compare notes on the challenges Japan faces, including deflation and the recent sharp appreciation of the yen that is threatening exporter profits.

Economists have said an increase in outright purchases of Japanese government bonds would be an option for the BOJ can take in order to cope with deflation.

But Shirakawa said earlier this month that injecting more liquidity into the financial system is unlikely to boost prices when final demand remains weak, suggesting that monetary policy will have a limited effect on pulling the Japanese economy out of deflation.

"When the overall economy faces a large liquidity constraint, adding liquidity should have a big impact in halting price drops," he told a news conference on Nov. 20. "But when the economy lacks investment not because of a liquidity crunch, in other words, when there is a shortage of demand, adding liquidity alone won't help push up prices."

In today's speech, Shirakawa repeated his view.

"The starting point of the current price decline was the rapid contraction of financial and economic activities since the autumn of last year, and as a result, the supply and demand balance deteriorated significantly," he explained.

"In order to deal with such situation, it is necessary to prepare an environment conducive to a sustainable expansion of final demand, such as business fixed investment and private consumption."

Shirakawa also said, "The bank will thoroughly check the future developments in the economy and prices and take appropriate policy response to bring Japan's economy back to a sustainable growth path with price stability."

The governor vowed to act swiftly to ensure financial stability which has been maintained relatively well in Japan despite the global financial crisis, but didn't specify what action he had in mind.

"In terms of the effects of monetary easing, it is important to ensure the stability of financial markets," he said. "To ensure the stability of the financial markets is a responsibility as a central bank, and I will reemphasize that the bank is always prepared to act promptly and decisive if judged necessary to ensure the stability of financial markets."

Shirakawa also said, "Deflation is caused by a lack of demand, so countermeasures to cope with deflation means economic stimulus measures. It is necessary to increase demand."

As for foreign exchanges, he said, "The bank pays due attention to the effects of the recent rapid appreciation of the yen on business sentiment of the firms that are on the road to recovery, as well as to the effects of international financial developments since last week on the financial markets."

"It would be important, above all, for a central bank to examine the economy without prejudgment."

In response to questions, Shirakawa replied, "I'm aware that movements of foreign exchange rates have a big impact of corporate earnings. We strongly hope that foreign exchange rates will move in a stable manner."

He added that the BOJ does not have the authority to take action in the forex market. The Ministry of Finance decides on forex intervention and the BOJ steps in the market on its behalf.

On the global economy, Shirakawa said while the panicked contraction of economic and financial activity settled down mainly due to the provision of ample liquidity by central banks, public capital injections to financial institutions, and large-scale fiscal expenditure, chronic downward pressure on the economy is likely to continue in the form of balance-sheet adjustments.

On Japan's economy, he said, "It cannot be denied that there is a possibility that the momentum for Japan's economic recovery will temporarily slow at around the spring of 2010, when the effects of economic stimulus measures will wane at home and abroad."

He added that "a possibility that the momentum for economic recovery at home and abroad will stall seems not so significant."

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