By Leika Kihara
TOKYO (Reuters) - The Bank of Japan should dial back its massive stimulus before inflation hits its 2 percent target, a leading candidate to become the next governor said, raising questions about the efficacy of the BOJ's radical approach to snuff out deflation in the world's third-largest economy.
The proposal by former BOJ Deputy Governor Kazumasa Iwata goes against the central bank's pledge that it will maintain its stimulus program until its elusive inflation goal is met.
Calling for a change of strategy by the BOJ, Iwata criticized the central bank's price forecasts as too optimistic and warned that even hitting 1 percent inflation could be challenging given a recent batch of weak price data.
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His comments, the strongest criticism on the BOJ's policies to date by a former deputy governor, underscore growing concern over the strains the BOJ's prolonged ultra-easy policy is putting on the country's banks and financial market.
With the demerits of extraordinary stimulus becoming clearer, the BOJ should slow purchases of government bonds and exchange-traded funds (ETF) - trust funds investing in stocks - even though inflation is nowhere near its target, he said.
"The BOJ should slow its annual bond buying to around 40 trillion yen ($362 billion) from the current 80 trillion yen. That would make its policy more sustainable," Iwata told Reuters on Monday, calling on the bank to proceed with a slowdown in its bond buying that is already underway.
He also said the bank should consider reducing ETF buying at some point, given the distortions it is creating in the market.
"Once it becomes clear inflation will stay around 1 percent, the BOJ should modify its long-term interest rate target. But even the road to hitting 1 percent inflation appears pretty tough, judging from recent data," said Iwata, now president of private think tank Japan Center for Economic Research.
One idea would be to allow for a natural rise in long-term interest rates by targeting five-year bond yields rather than the current 10-year yields, he said.
Iwata's views on monetary policy are closely watched as he is seen by markets as among the few strong contenders to replace Governor Haruhiko Kuroda when his five-year term ends in April.
"Iwata may be a dark horse but his experience as deputy governor during difficult times for the economy makes him a strong candidate as next governor," said Mari Iwashita, chief market economist at SMBC Friend Securities.
"Iwata's proposals on tapering are realistic. It might be hard to roll back all the policies Kuroda put in place, but the BOJ may gradually start to shift to a more flexible approach toward policy normalization," she said.
It is the first time Iwata has elaborated on his recommendations for a fresh BOJ strategy to help taper its massive stimulus, suggesting that a hard inflation target poses problems for policy.
LEARNING FROM 2007
The BOJ revamped its policy framework last year to one controlling the yield curve from that targeting the pace of money printing. It now guides short-term rates at minus 0.1 percent and 10-year bond yields around zero percent.
It also maintains a pledge to increase its bond holdings at an annual pace of 80 trillion yen. Some analysts believe the BOJ will soon abandon the pledge as the pace of bond buying has recently slowed to around 60 trillion yen.
The warning from Iwata of the cost of prolonged easing is significant because he had long cautioned against the risk of a premature withdrawal of stimulus.
During his term as deputy governor from 2003 to 2008, Iwata dissented to a rate hike decision in 2007 on the view inflation was too weak. Indeed, prices slid after the move and the BOJ came under fire for tightening too quickly.
The BOJ should learn from its experience in 2007 and avoid being overly optimistic on the price outlook, he said.
"It's wrong to assume inflation will accelerate just because economic growth is strong."
Asked whether he was keen to succeed Kuroda as next BOJ governor, Iwata said: "It's best for Kuroda to see through the exit" as ending ultra-loose policy is "tough."
Inflation is currently running at an annual pace of 0.4 percent, well off the BOJ's 2 percent goal which it hopes to hit during the fiscal year ending in March 2020.
(Additional reporting by Sumio Ito; Editing by Shri Navaratnam)