KOFU, Japan (MNI) - Bank of Japan board member Miyako Suda said on Wednesday that the BOJ must continue crafting the most effective money market operation tools in step with developments in financial markets.

She also warned that continued price drops could trigger a deflationary spiral and urged a close watch on the appreciation of the yen, which could hurt Japan's recovering exports while lowering import costs. This in turn could lead businesses and households to believe that prices will fall further, discouraging them from investing and spending.

In a speech to business leaders in Kofu City, central Japan, Suda said, "Yesterday we decided to adopt what we believed to be the most effective monetary policy tool for supporting an economic recovery. Looking ahead, we will continue conducting the best possible money market operations by comparing their benefits with their costs."

She didn't specify what other policy options the BOJ may take in the future.

As for deflation, Suda warned that if the current price drops are prolonged, they could delay a revival in consumer spending, and combined with a drop in inflation expectations, they could trigger a deflationary spiral in which lower prices cause wage cuts and hurt the economy, which in turn would depress prices further.

"The BOJ needs to pay attention to the impact of the recent rapid rise in the yen on the real economy and needs to be aware of the risk that weaker domestic and overseas economies, together with the strong yen, could lower inflation expectations," she said.

The board member also said the year-on-year drop in Japan's core consumer price index is expected to moderate to be around -1.0% toward the end of the year.

Japan's core consumer inflation rate fell 2.2% in October, posting the eighth straight year-on-year decline as the costs of gasoline, heating oil and overseas holiday tours continued to show sharp declines from year-earlier levels.

But the pace of price drops slowed slightly for the second month in a row, easing from -2.3% in September and the record -2.4% in August as the energy costs were not as far below their summer 2008 peaks than in previous months.

Suda said the large slack resulting from the sharp economic downturn that hit the world from late last year to early this year is likely to continue to exert downward pressure on prices and thus the pace of the projected improvement in prices should remain modest.

In a hurriedly called meeting on Tuesday, the BOJ board voted unanimously to leave its target for the overnight lending rate among commercial banks at 0.1% to prop up the economy, while deciding, also unanimously, to launch a new fixed-rate money market operation in order to "further enhance easy monetary conditions." The new three-month funding, which will be lent out at a fixed rate of 0.1%, will total Y10 trillion. The bank said the aim of the new operation is to "encourage a further decline in longer-term interest rates," meaning this could push down money market rates for funds up to one year in maturity.

The new operation is "quantitative easing in a broad sense" as the BOJ is trying to avoid a shortage of liquidity from limiting financial firms' activities, BOJ Governor Masaaki Shirakawa told reporters after Tuesday's meeting.

The new three-month facility is a permanent operation, unlike other temporary measures designed to help Japan overcome the fallout from the global financial crisis and recession. The BOJ plans to begin the new operation early this month, injecting about Y800 billion weekly. The BOJ noted that "there is a risk that recent international financial developments and foreign exchange market instability might pose adverse effects on economic activity through impacts on business sentiment and others, and this warrants attention."

The BOJ's decision is aimed at protecting a fragile economic recovery from the impact of the sharp appreciation of the yen against the dollar and the drop in Japanese share prices.

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