By Leika Kihara
TOKYO (Reuters) - The Bank of Japan (BOJ) must make its monetary policy framework more flexible and stand ready to raise its long-term interest rate target next year if the economy can withstand overseas risks, former deputy governor Hirohide Yamaguchi told Reuters.
Yamaguchi, who is considered a candidate to become next BOJ governor, said Japan is already seeing signs of "home-made" inflation, in which broadening price hikes heighten public perceptions that inflation will keep rising longer-term.
Wages are also likely to rise ahead on robust corporate profits, which could keep inflation above the BOJ's 2% target well into next year, he said in an interview on Friday.
"There's a chance core consumer inflation may stay around 3-4% for a fairly long period," Yamaguchi said. "Once inflation expectations become entrenched, it's very hard for central banks to control them. That's a risk the BOJ should be mindful of."
Markets are rife with speculation the BOJ could tweak yield curve control (YCC) - a controversial policy combining a negative short-term rate target with a 0% cap on the 10-year bond yield - when Governor Haruhiko Kuroda's term ends in April.
If Japan's economy can withstand headwinds from an expected slump in U.S. growth, the BOJ should raise its 10-year bond yield target next year, Yamaguchi said.
"When prices start rising, it's very hard to maintain yield curve control" as long-term rates face upward pressure, he said.
The remarks contrast with those of Kuroda, who has dismissed the chance of a near-term rate hike on the view the recent rise in inflation will prove temporary.
"The BOJ will find it too risky to abandon YCC in a single blow. If so, the natural answer would be to adjust YCC in small steps," Yamaguchi said. "One idea could be to raise the 10-year yield target and set an allowance band around it."
The BOJ must also ditch a pledge to keep increasing the pace of money printing until inflation "stably exceeds" 2%, Yamaguchi said.
"The BOJ must get rid of commitments that bind its policy, so it can respond flexibly and nimbly to changes in the economy as needed," Yamaguchi said. "Essentially, it's reverting to the basics of monetary policy."
The BOJ is facing increasing public criticism for the rising cost of prolonged ultra-low interest rates, such as the hit to bank margins and a yen plunge that has raised import costs.
Kyodo news agency reported on Saturday the government is set to revise a joint statement with the BOJ, signed in 2013, to water down the price goal and give its policy more flexibility.
Yamaguchi, who played a key role in crafting the statement in 2013, said the existing language does not necessarily prevent the BOJ from guiding policy more flexibly.
"I don't see any necessity to change the BOJ's joint statement with the government at this moment," he said.
Yamaguchi served as deputy governor for five years until 2013 under Kuroda's predecessor Masaaki Shirakawa. The 2013 statement he helped draft commits the BOJ to meet its 2% inflation "at the earliest date possible."