Japan will resume its recovery at a moderate pace until the end of 2006 but faces "serious headwinds to sustained growth", the Organisation for Economic Co-operation and Development (OECD) said yesterday.

Long-term prospects continued to be dogged by "entrenched deflation" and a sustained fall in bank lending and land prices, it said in its annual report, which also urged more urgent fiscal consolidation and aggressive deregulation.

The report said the Bank of Japan (BoJ) should take more decisive measures to end deflation, including raising the threshold for an exit from its quantitative easing policy to a price rise of 1 per cent from the current zero per cent. That amounted to a call for an inflation target, an approach the BoJ has resisted.

The OECD's judgment that the economy will bounce back after six months of virtually no growth will cheer those who fear Japan stands on the brink of another recession.

Calling the current recovery cycle, which began in early 2002, the "strongest since the 1980s", it said corporate restructuring, a more solid banking sector and strong demand from China would help keep growth on track.

"The expansion is projected to continue through the end of 2006, though at a more moderate pace of around 2.25 per cent," it said.

However, the report highlighted several obstacles to sustained healthy growth in the medium term.

It called Japan's chronic budget deficits, which have pushed gross debt to 160 per cent of gross domestic product, "unsustainable" and urged the implementation of more aggressive spending cuts and tax-raising measures.

Those recommendations echo the finance ministry's stance, but will put the OECD in conflict with other economists who say fiscal tightening while prices continue to fall is dangerous.