Feb. 21 (Bloomberg) -- The Bank of Japan raised its benchmark interest rate to 0.5 percent after the world's second- biggest economy expanded at the fastest pace in three years.

Governor Toshihiko Fukui and his policy board colleagues voted 8-1 to increase the overnight lending rate from 0.25 percent, the bank said in a statement today in Tokyo. Japan's rates are still the lowest among major economies. Deputy Governor Kazumasa Iwata voted against the increase.

The central bank said further increases will be gradual and that prolonging a low-interest-rate policy could spur overinvestment and asset bubbles. Higher rates may discourage investors from borrowing in yen to buy overseas assets, the so- called carry trade that helped drive Japan's currency to a 21- year low against its trading partners.

``Bank of Japan board members had to balance weaker activity and inflation over the near term with the ever- increasing risk of low rates triggering an overheating of the economy further down the line,'' said Ben Eldred, a Japan strategist at Daiwa Securities Group Inc. in London.

The yen traded at 121.08 per dollar at 10:30 a.m. in New York from 120.02 late yesterday. The Bank of Japan won't raise interest rates at consecutive board meetings and has no predetermined schedule for rate increases, Fukui said at a press conference.

The yen today fell against the 16 most-active currencies, with its worst performance versus the Australian and New Zealand dollars. Australia's overnight cash rate target is at a six-year high of 6.25 percent and New Zealand's official cash rate is 7.25 percent.

`Carry Trade'

``We're aware that extremely distorted movements in the financial market, including the yen-carry trade, could eventually have a negative impact on the economy,'' Fukui said. He said today's decision was focused more on the economy than the potential effect of the carry trade.

The yield on the benchmark 10-year bond fell 2 basis points to 1.685 percent.

``The rate hike this time could be the last one for this year as inflation expectations aren't rising and consumer spending still looks fragile,'' said Tokyo-based Yoshimasa Kato, a deputy general manager at the investment division of Shinkin Trust Bank Ltd.

Economic Recovery

Japan's economy expanded at an annual 4.8 percent pace in the three months ended Dec. 31, up from 0.3 percent in the previous three months, a government report showed last week.

Consumer spending rose 1.1 percent, after dropping at the same rate in the third quarter. Business investment expanded 2.2 percent, up from 0.8 percent.

``I expect another small hike by 25 basis points in the fourth quarter of this year,'' said Dariusz Kowalczyk, senior investment strategist at CFC Seymour in Hong Kong. ``They are still concerned more aggressive tightening could bring a return of deflation, something that had plagued the Japanese economy for many years.''

The bank said it expects the economy to continue to expand moderately. Weak consumer spending observed during Japan's summer was probably only temporary, the bank said today.

Fukui cited weak consumer spending and slow price growth as reasons for keeping rates on hold at the bank's December and January meetings. The bank last raised rates in July.

`Normalized' Rates

``What this means is that the private sector-led economic recovery in Japan is sustainable and the Bank of Japan is determined to slowly put monetary policy at a more normalized level,'' said James McCormack, head of Fitch Ratings' Asian sovereign ratings group in Hong Kong.

The bank said a decline in oil costs may cause core consumer prices, which include energy, to drop temporarily. Prices will rise in the medium to long term, it said.

Core consumer prices, which exclude fresh food, rose 0.1 percent in December, slowing from 0.2 percent in November.

The weak outlook for core consumer prices may explain why Deputy Governor Iwata voted against today's increase. Iwata, 60, has argued since at least November 2005 that low interest rates are necessary until the bank can foresee core inflation rising to about 1 percent.

Iwata's Vote

``Iwata was always going to be reluctant for Fukui to propose a rate rise,'' especially considering Japan's weak price growth, said Glenn Maguire, chief economist for Asia at Societe Generale SA in Hong Kong.

Maguire forecasts core prices will drop 0.2 percent in March from a year earlier. ``This will prove to be particularly problematic for the bank going forward,'' he said.

Concerns that economies such as the U.S. may slow ``are abating,'' reinforcing the prospects for rising corporate profits and business fixed investment, the bank said.

The U.S. economy, destination for more than a fifth of Japanese exports, grew at an annual 3.5 percent pace in the fourth quarter, the fastest in a year.

Bank of Japan policy makers have said since at least October 2005 that rates should be gradually raised from near zero percent, where until July they were held for more than five years to help beat a decade of deflation.

The central bank today raised the so-called Lombard rate, with which it directly lends overnight funds to its member banks, to 0.75 percent from 0.4 percent.

`Sense of Security'

``The decision to hike interest rates will promote a sense of security over monetary policy in the long run,'' said Fumiaki Watari, chairman of the Petroleum Association of Japan. ``That will also have a favorable effect on investment in Japan.''

Today's decision was considered a close call by analysts. Twenty-seven of 52 economists predicted rates would be left at 0.25 percent.

Government opposition was relatively muted in the lead up to this week's meeting, in contrast with comments before the Jan. 18 move to keep rates on hold. The decision flummoxed investors, who only days before had bet on an increase, and fanned suspicions that the bank had caved in to political pressure.

Hidenao Nakagawa, secretary general of the Liberal Democratic Party last month said the government should consider exercising its right to ask the bank to delay a decision. The government didn't make that request today.

Nakagawa today joined Japan's Economic and Fiscal Policy Minister Hiroko Ota in saying that the Bank of Japan would take responsibility for the consequences of a rate increase.

The government's ``chilly, tacit acceptance of the move was based on the reasoning that the BOJ would be left accountable for any subsequent slowing of the economy,'' said Shinichi Ichikawa, chief strategist at Credit Suisse Group in Tokyo.

To contact the reporter on this story: Mayumi Otsuma in Tokyo motsuma@bloomberg.net

Last Updated: February 21, 2007 10:31 EST