The International Monetary Fund on Friday proposed the Bank of Japan allow for more flexibility in long-term Japanese government bond yields that have been kept at depressed levels amid the "costly" side-effects of prolonged monetary easing.
In its assessment report on Japan's fiscal and monetary policy released just before Governor Haruhiko Kuroda hands the reins to his successor, the IMF also stressed that accommodative monetary policy is appropriate.
The IMF report, compiled after bilateral consultations with Japan, proposed three options for the BOJ to consider as part of a review of the central bank's program to keep borrowing costs extremely low through massive purchases of Japanese government bonds.
Incoming BOJ Governor Kazuo Ueda, who will assume the post on April 9, has left open the possibility of overhauling the yield curve control program blamed for distorting bond markets.
"Noting two-sided risks to inflation, directors encouraged the (Japanese) authorities to consider options for introducing more flexibility under the yield curve control framework to better manage those risks and help address the side effects of prolonged easing," the IMF said.
The Washington-based body underscored the need for the BOJ to give "clear guidance" on the preconditions for a future policy rate change, saying that upside risks to inflation are more prominent.
Japan's inflation has been above the BOJ's 2 percent target for nearly a year. But the central bank has taken the view that most of it is attributable to higher import costs of energy and raw materials.
Under the current projections, the core consumer price index, the key gauge of inflation, will undershoot the target in the latter half of 2023.
The BOJ sets short-term interest rates at minus 0.1 percent while guiding 10-year yields to around zero percent. Within that framework, it raised the allowed limit for the 10-year yield to 0.5 percent in a surprise December move, fueling market speculation of monetary tightening and leading yields to jump.
The IMF's proposals include widening the target for 10-year Japanese government bonds, shortening its yield curve target, or shifting the focus to the quantity of bond purchases.
The IMF said "any changes to monetary policy settings will need to be well communicated to facilitate smoother transitions and protect financial stability."
In recent weeks, banking concerns sparked by the collapse of two U.S. banks and a rescue of Swiss lender Credit Suisse have boosted the safety appeal of government bonds and their yields have been trending lower. Japanese authorities have said the Japanese banking system is stable as financial institutions have ample liquidity.
The banking concerns and subsequent market rout have added a layer of uncertainty over the economy. Despite quickening inflation, Japan's economy is expected to receive support from pent-up demand in the aftermath of the COVID-19 fallout, the easing of supply chain disruptions and border controls, and policy steps.
Still, the IMF downgraded its growth outlook for Japan to 1.3 percent this year from its earlier forecast of 1.8 percent.
While "exceptionally high" uncertainty remains over the price outlook, "Japan's largely backward-looking inflation expectations could prolong high inflation once it emerges," the IMF said.
The BOJ bond-buying has helped the government curb debt-servicing costs even as the COVID-19 pandemic and Russia's invasion of Ukraine prompted the debt-saddled nation to increase fiscal spending, most recently a fresh inflation-relief package worth 2.2 trillion yen ($16.6 billion) unveiled ahead of local elections.
The IMF said "pandemic-related fiscal support should be withdrawn in a timely manner" and assistance should focus on vulnerable households.