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TOKYO, Aug 8 (Reuters) - The Bank of Japan should dial back its massive stimulus before inflation hits its 2 percent target, a leading candidate to become the next governor said, raising questions about the efficacy of the BOJ's radical approach to snuff out deflation in the world's third-largest economy.
Former BOJ Deputy Governor Kazumasa Iwata criticised the central bank's price forecasts as too optimistic and warned that even hitting 1 percent inflation could be challenging given a recent batch of weak price data.
The comments underscored growing concern over the strains the BOJ's prolonged ultra-easy policy is putting on the country's banks and financial market.
With its huge bond buying nearing a limit and the demerits of extraordinary stimulus becoming clearer, the BOJ should slow its purchases of government bonds and exchange-traded funds (ETF) - trust funds investing in stocks - even though inflation is nowhere near its target, he said.
"The BOJ should slow its annual bond buying to around 40 trillion yen ($362 billion) from the current 80 trillion yen. That would make its policy more sustainable," Iwata told Reuters on Monday, calling on the bank to proceed with a slowdown in its bond buying that is already underway.
He also said the bank should consider reducing ETF buying at some point, given the distortions it is creating in the market.
"Once it becomes clear inflation will stay around 1 percent, the BOJ should modify its long-term interest rate target. But even the road to hitting 1 percent inflation appears pretty tough, judging from recent data," said Iwata, now president of private think tank Japan Center for Economic Research.
Iwata's views on monetary policy are closely watched as he is considered by markets as among the few strong contenders to replace Governor Haruhiko Kuroda when his five-year term ends in April.
One idea would be to allow for a natural rise in long-term interest rates by targeting five-year bond yields rather than the current 10-year yields, he said.
The BOJ revamped its policy framework last year to one controlling the yield curve from that targeting the pace of money printing. It now guides short-term rates at minus 0.1 percent and 10-year bond yields around zero percent.
It also maintains a pledge to increase its bond holdings at an annual pace of 80 trillion yen. Some analysts believe the BOJ will soon modify or abandon the pledge as the pace of bond buying has recently slowed to around 60 trillion yen.
Inflation is currently running at an annual pace of 0.4 percent, well off the BOJ's 2 percent goal which it hopes to hit during the fiscal year ending in March 2020.
($1 = 110.6200 yen)
(Additional reporting by Sumio Ito; Editing by Shri Navaratnam)