By Tetsushi Kajimoto and Stanley White
TOKYO (Reuters) - The International Monetary Fund urged Japan to avoid withdrawing fiscal policy stimulus and said monetary policy should be loosened further if risks to the economy materialise, warning of weak consumption that remains vulnerable to external shocks.
While the BOJ should maintain its ultra-loose policy, it should do so by focusing on capping long-term interest rates under its yield curve control policy, the IMF said.
To clarify that stance and enhance communication of its policy, the central bank should "phase out" a loose pledge to keep increasing its government bond holdings at an annual pace of 80 trillion yen ($721 billion), it said.
"The BOJ should carefully calibrate its yield curve policy, if downside risks materialise, to provide additional monetary easing," the IMF said in its annual Article 4 evaluation of Japan's economy.
IMF Deputy Managing Director David Lipton told reporters that the BOJ's new monetary policy framework was already showing some success by bringing down market volatility and stabilising the bond yield curve.
"We're comfortable with the stance of (BOJ) monetary policy. Recent changes to the monetary policy ... (are) the right, useful approach," Lipton told a news conference.
"What's important is the maintenance of the approach that has been laid out and accompanying it with structural and fiscal agenda," he said.
The IMF also called on Japan to keep its near-term fiscal stance neutral and avoid withdrawing stimulus in 2018.
To balance the need to sustain economic growth and achieve medium-term fiscal consolidation, Japan should gradually increase the consumption tax until it reaches at least 15 percent and start the process "as soon as possible," it said.
"The expiration of fiscal support in 2018 under current policies together with a smaller expansion in foreign demand would reduce growth to less than half of that in 2017," the IMF said in its annual Article 4 evaluation of Japan's economy.
"Without additional spending, the fiscal stance could become contractionary in 2018–20 due also to the scheduled consumption tax hike in October 2019."
The nation's sales tax is now at 8 percent. The government has pledged to raise it to 10 percent in October 2019.
Japan also needs to move faster on reforms to increase productivity, diversify the labour market and increase corporate investment, the IMF said.
Under a new policy framework adopted last year, the BOJ now targets interest rates rather than the pace of money printing.
But it left a loose pledge to buy government bonds so its holdings increase at an annual pace of 80 trillion yen, partly to appease advocates of aggressive asset purchases in the BOJ's nine-member board.
($1 = 111.0300 yen)
(Additional reporting by Leika Kihara; Editing by Chang-Ran Kim & Shri Navaratnam)