Fiscal policy must play key role in supporting Japan's economy - ex-BOJ exec

By Leika Kihara

TOKYO (Reuters) - Fiscal policy must play a key role in supporting Japan's economy if overseas risks threaten to derail a fragile recovery, as the central bank has little left in its policy tool kit, a former Bank of Japan executive said on Tuesday.

Kazuo Momma, who retains close contact with current BOJ officials, said it would be best if the central bank refrained from expanding an already massive stimulus for as long as needed, given the rising cost of prolonged easing.

But if the BOJ is forced to address an abrupt yen spike that hurts Japan's export-reliant economy, the only option left would be to push short-term interest rates deeper into negative territory, said Momma, who is now an executive economist at private think tank Mizuho Research Institute.

Momma oversaw monetary policy and international affairs during his stint at the central bank, and his views are closely watched by policymakers and market participants.

"If it turns out that the economy needs further support, it ought to come from fiscal policy," Momma said, adding the government still had room to ramp up spending if external shocks cool demand and tips the economy into recession.

"As for monetary policy, the only feasible and possible tool the BOJ has left going forward is to deepen negative rates," he told Reuters.

If the BOJ were to ease further, it will likely accompany the move with measures to ease the burden ultra-low rates have placed on financial institutions, Momma said.

Under a policy dubbed yield curve control (YCC), the BOJ guides short-term rates at -0.1% and the 10-year bond yield around 0%.

Years of heavy money printing have failed to fire up inflation to the BOJ's 2% target, forcing it to maintain a massive stimulus despite the squeeze on financial institutions' profits from ultra-low rates.

The BOJ is set to keep policy steady on Thursday, preferring to save its dwindling ammunition to support growth.

Reflecting receding expectations of imminent easing, a Reuters poll showed an increasing number of analysts predicting the BOJ's next move will be to dial back stimulus.

With the economy showing signs of weakness, the government has compiled a $122 billion fiscal package as a pre-emptive step to ward off heightening overseas risks.

Momma said while Japan will likely avert a recession next year, core consumer inflation will hover around 0.5% to 1% - well short of the BOJ's target.

That means in the long run, the BOJ would need to find ways to wind down YCC and negative rates - both "extreme" policies required only in times of crisis, said Momma.

"The role of the BOJ's 2% inflation target has changed dramatically" from the time Governor Haruhiko Kuroda deployed his massive asset-buying programme in 2013, he said.

"For the BOJ, it's no longer an active target that must be achieved by all means. It has become a passive one, in which the BOJ waits patiently until inflation creeps up."

(Additional reporting by Hiroko Hamada; Editing by Jacqueline Wong)