* Visco warns inflation expectations could fall suddenly
* Says low euro zone bond yields may not last long
* Says Italy recovery prospects uncertain, must increase investment (Adds data from Bank of Italy's report, details)
By Gavin Jones
ROME, May 30 Excessively low inflation in the euro zone should be dealt with as firmly as high inflation, ECB Governing Council member Ignazio Visco said on Friday, adding that a strong euro had helped push inflation too low.
He reiterated that the European Central Bank was ready to use unconventional policies if new staff forecasts confirm inflation is set to remain well below the ECB's target of just under 2 percent for the next two years. The euro zone central bank's policymakers next meet on June 5.
The ECB's main refinancing rate stands at a record low of 0.25 percent and the bank is expected to cut it and other interest rates further at its June meeting and adopt other measures aimed at boosting lending to smaller firms.
Euro zone inflation stood at just 0.7 percent in April and is expected to remain at the same level in May.
Visco, who is also Bank of Italy governor, said the speed with which inflation expectations can change meant decisive action was needed to head off any risk of a deflationary spiral.
"The exchange rate is not in itself a monetary policy target, but at this stage the euro's appreciation has compressed consumer price inflation," Visco also told the Italian central bank's annual assembly.
Italian EU-harmonised consumer prices were up just 0.4 percent annually, falling short of forecasts for a 0.6 percent annual rise, data on Friday showed.
In its annual report published on Friday, the central bank said foreign investors bought a net 37 billion euros of Italian bonds in the first quarter of this year, compared with a net 13 billion euros in all of 2013.
This showed a clear reversal of the trend started in the last months of 2011, when foreign investors shed Italian debt massively as the country was engulfed in the sovereign debt crisis.
Visco warned, however, that historically low yields on euro zone government bonds may not last indefinitely and that global yields could rebound in response to a less expansionary monetary policy in the United States.
"Volatility on the financial markets in the advanced economies has subsided to well below the historic norm, reaching levels that in the past sometimes preceded rapid changes in the orientation of investors," he added.
While euro zone policymakers had responded to the region's debt crisis by strengthening fiscal rules, multilateral surveillance and establishing common funds to help countries in difficulty, much remained to be done, Visco said.
"Banking union, now being implemented, should be followed by the creation of a true common budget," he said, adding that the euro zone suffers from being "a currency without a state".
Visco said Italy's exit from six years of recession and stagnation was proving "laborious" and stressed the need to increase investment, which fell in 2013 to 17 percent of gross domestic product, the lowest level since World War Two.
Industrial output has fallen by 25 percent and with thousands of firms going out of business the country's manufacturing capacity has shrunk by 15 percent, he said.
Italy's economy shrank 0.1 percent in the first quarter of 2014 after GDP edged up 0.1 percent late last year, its first sign of growth for two years.
Visco said the Bank of Italy would in the next few weeks adopt measures to improve banks' liquidity so they can increase lending to credit-starved small and medium sized companies.
Next month the Bank of Italy will unveil measures to enable domestic banks to use their current account facilities as collateral to secure ECB funding, banking sources told Reuters some weeks ago, disclosing one the tools the central bank would use to improve financing condition for small firms.
Current account facilities, which allow small businesses to borrow up to an agreed amount while they are waiting for customers to pay them for their goods, were estimated to provide up to 180 billion euros in funds to Italian firms last year.
Visco also called for banks to continue disposing of bad loans on their books and said there may be a market for these loans from national and international investors. (additional reporting by Stefano Bernabei, Editing by Catherine Evans)