The Bank of Japan's (BOJ) toolkit may be running short, with the few levers left unlikely to help the central bank reach its inflation target, a former BOJ board member said.
Sayuri Shirai, whose five-year term at the BOJ ended on March 31, said Japan faced "very sluggish potential economic growth and also very low economic growth."
"Without being able to increase this potential economic growth, it's very difficult for BOJ to achieve a 2 percent [inflation target], because right now, aggregate demand and credit demand are not very large," she told CNBC's "Squawk Box" on Monday.
The outcome of Wednesday's BOJ meeting, due after 10 a.m. SIN/HK, will likely be a bigger nail-biter than usual. That's because there is such a wide range of predictions on what the central bank, which has also promised a comprehensive assessment of its current quantitative and qualitative easing (QQE) and negative interest rate policies, may do.
Those predictions have varied from expectations the BOJ will cut interest rates deeper into negative territory, to changing the size or make-up of its QQE asset purchases, to trying to steepen the yield curve or to doing nothing at all.
Shirai said doing nothing at all wasn't likely to be an option.
She noted that failing to act, especially if the comprehensive assessment found that it would take longer than the expected fiscal 2017 to achieve the 2 percent inflation target, would be inconsistent with previous communication from BOJ Governor Haruhiko Kuroda.
"I think the BOJ have to show additional action," she said, noting that previously, the central bank had said that if it appeared unlikely to reach its inflation target, it wouldn't hesitate to take further easing measures.
But Shirai, who was one of four board members who voted against the negative interest rate policy that was adopted at the BOJ's January meeting, noted the limitations of expanding existing policies.
"I don't think negative interest rates will contribute to increasing aggregate demand and also increasing inflation expectations," Shirai, who is currently a guest professor at Keio University, said. "But if Mr. Kuroda has to show some action in order to admit that it takes longer for them to achieve 2 percent, I think negative interest rate is one of only a few remaining options. Because comparing to additional QE, negative interest rate policy has less side effect."
Shirai cited concerns that not only were the BOJ's purchases of Japanese government bonds (JGB) distorting markets, but that the quantitative-easing policy was nearing its limits. She noted that the BOJ's bond purchases were already approaching 40 percent of the JGB market.
"They can technically buy more," said Shirai, who has also previously worked as an economist at the International Monetary Fund. But she noted that those purchases would take JGBs from institutional investors and commercial banks that needed to hold them.
"It's going to be much harder for BOJ to continue this asset purchase program unless the BOJ pays very high prices and then that would undermine the BOJ's balance sheet," she said. "Also, at this moment, the yield curve is very flat. So if the yield curve is too flat then what would happen to the lending rate or bond prices? Those would not reflect the appropriate prices any longer."
The BOJ's purchases of government bonds have pushed down interest rates in general. The 30-year JGB was yielding only around 0.49 percent on Wednesday, not far above the 10-year JGB's around negative 0.056 percent and the two-year's around negative 0.261 percent. A flatter yield curve weighs on the earnings of banks as they borrow at short-term rates to lend at long-term rates; the lack of compensation for taking on risk also tends to discourage banks from lending.
While many analysts predicted the BOJ might try to steepen the yield curve again, Shirai was concerned about the potential market impact.
"If the BOJ tried to affect the yield curve, then market participants and the public would not know whether the BOJ is still targeting monetary base or interest rates," she said. "It would only confuse the market."
With so much uncertainty on the BOJ's next move, Shirai also noted that there was geographic divide on the potential outcome, with those inside Japan expecting a lot less from the central bank.
"Outside of Japan, they tend to view that in order to achieve higher inflation, the BOJ must increase the asset purchase program together with the further expansion in fiscal policy," she said.
Last month, Japan's cabinet approved a $130 billion fiscal package in a bid to resuscitate economic growth, including both payouts to low-income earners and infrastructure spending. Officials expected the package would boost gross domestic product (GDP) by around 1.3 percent in the short term, Reuters reported. But while market watchers outside Japan may view that spending with some favour, within Japan, it was another story, Shirai noted.
"People here in Japan tend to have a more moderate view about what BOJ can do for the next actions," she said. "People [domestically] are increasingly concerned about debt sustainability issues, and those are people that view the tools available to the BOJ as running out."
Japan's government debt had reached nearly 250 percent of GDP last year, according to IMF data released in 2015, putting it among the highest in the world. The IMF said in 2015 that it expected the country's debt could reach nearly 300 percent of GDP by 2030.
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—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1