The Bank of Japan needs to - and likely will - ease monetary policy further even if the economy recovers, as any pickup in growth will be too small to pull the country out of deflation in the forseeable future, former BOJ Deputy Governor Toshiro Muto said.
Having set an inflation goal, the central bank should consider ways to achieve it - such as buying more Japanese government bonds (JGBs), targeting longer-dated bonds or boosting purchases of risk assets, said Muto, who was a top finance ministry bureaucrat before joining the BOJ.
"Japan's economy is picking up but the recovery is a very mild one," Muto, now chairman of private think-tank Daiwa Institute of Research, told Reuters in an interview on Friday.
"With such mild growth, it would take some time for Japan's output gap to narrow. As such, it would make sense to ease monetary policy further."
Under pressure to do more to beat deflation, the BOJ surprised markets in February by setting a 1 percent inflation goal and boosting its asset buying and loan scheme, under which it buys government bonds and private debt, by 10 trillion yen ($122 billion), to 65 trillion yen.
Muto said Japan's feeble economic growth meant it may not achieve consumer inflation of 1 percent in fiscal 2012 or 2013, or even in fiscal year 2014, which ends in March 2015.
The remarks by Muto, who still has strong influence over and contact with key policymakers and legislators, suggest that the BOJ will remain under pressure to do more despite February's action and an increasing number of bright signs in the economy.
"The February action turned out as a surprise. The BOJ did more than what was expected. On the other hand, there is room to do more. The real test has only just begun," Muto said. "The price goal has had a huge impact. Now, the BOJ will be asked to achieve it."
Muto, regarded as a strong candidate to succeed BOJ Governor Masaaki Shirakawa when his term expires early next year, said one option for the central bank would be to boost purchases of JGBs with longer dates until maturity.
The BOJ buys huge amounts of JGBs, but most are short-dated. That means a considerable portion of its bond holdings fall off its balance sheet regularly as they reach maturity, Muto said.
By buying more longer-dated bonds, the BOJ can increase the net balance of its bond holdings and sustain the effect of monetary stimulus longer, he said.
"Each of these steps might appear small. But markets will look at them in gauging the BOJ's determination," Muto said.
Under the asset buying programme, the BOJ will buy 19 trillion yen of JGBs with up to two years until maturity by a year-end deadline. It also buys 21.6 trillion yen in long-term JGBs annually in a separate market operation.
Muto, who served as deputy BOJ governor for five years until 2008, shrugged off the view of some analysts that the BOJ was already monetising debt, or printing money to finance public borrowing, with its massive purchases of JGBs. For a central bank that has stepped into quantitative easing, expanding its balance sheet is a policy tool so it is natural for the BOJ to increase government bond purchases, he said.