Feb. 15 (Bloomberg) -- Japan's economy grew at the fastest pace in almost three years as consumer spending rebounded and business investment jumped, stoking speculation the central bank may raise interest rates.

Gross domestic product in the world's second-largest economy expanded at an annual 4.8 percent pace in the three months ended Dec. 31, the Cabinet Office said in Tokyo today, exceeding the 3.8 percent median estimate of 38 economists surveyed by Bloomberg News. Third-quarter growth was revised to 0.3 percent from 0.8 percent.

The yen gained and the chance the Bank of Japan will raise rates next week climbed to 54 percent, from 40 percent late yesterday, according to calculations by Credit Suisse Group based on interest-payment trading. Governor Toshihiko Fukui cited weak consumer spending and slow inflation as reasons his policy board kept borrowing costs at 0.25 percent at its last two meetings.

``The report increases the possibility the central bank will raise rates,'' said Satoshi Kon, who helps manage the equivalent of $19 billion in Tokyo at Pension Fund Association. ``Consumption was stronger than many of us anticipated.''

The yen rose to 119.96 per dollar at 4:59 p.m. in Tokyo from 120.72 before the report was published. Yields on the benchmark 10-year bond rose 1.5 basis points to 1.74 percent. The Nikkei 225 Stock Average climbed 0.8 percent as shares of Takashimaya Co., the nation's largest department store, jumped 10 percent.

Cabinet Ministers

Some investors had lowered expectations for a February rate increase after reports showed wages had the biggest drop in 16 months in December, inflation slowed, and machinery orders fell, raising concern companies may scale back investment.

Governor Fukui has said the central bank will gradually raise rates if the economy and prices keep expanding in line with its expectations. Cabinet ministers today urged the central bank to consider the government's position when deciding whether to increase borrowing costs.

``Monetary policy is the domain of the Bank of Japan and should be decided appropriately, taking into account the government's views,'' Chief Cabinet Secretary Yasuhisa Shiozaki said. Economic and Fiscal Policy Minister Hiroko Ota said the bank should support the economy with its monetary policy.

The bank averted a potential clash with government officials when it kept rates on hold last month. Prime Minister Shinzo Abe's government, focusing on policies to spur growth and stop the expansion of the world's largest public debt, wants to avoid an economic slowdown ahead of elections in April and July.

U.S. Economy

Before last month's policy meeting, expectations for a rate increase waned from an 80 percent chance on Jan. 16 to 28 percent the day before the decision, after media reports said the bank would keep borrowing costs on hold amid pressure from politicians.

In 2006, Japan's economy expanded 2.2 percent, the fastest pace in two years, today's report showed. That compares with 3.4 percent growth in the U.S., Japan's largest export market, and a 2.7 percent expansion in Europe.

``The growth outlook for the U.S. economy is looking better, and with a weaker yen, that will provide a tailwind for the Japanese economy,'' said Peter Morgan, chief Asia-Pacific economist at HSBC Holdings Plc in Hong Kong. The yen has declined 11 percent against the euro in the past 12 months and 1.8 percent against the dollar.

A rate increase may support the yen as investors reverse carry trades, where they borrow cheaply in Japan to buy higher- yielding assets overseas. European officials are concerned that a weaker yen hurts their exporters.

Japan's 0.25 percent key rate, the lowest among major economies, compares with the European Central Bank's 3.5 percent and the U.S. Federal Reserve's 5.25 percent.

Consumer Spending

From the previous quarter, the economy grew 1.2 percent, today's report showed. Consumer spending rose 1.1 percent, faster than the 0.8 percent predicted by economists. Spending dropped a revised 1.1 percent in the third quarter, more than the 0.9 percent previously estimated.

Spending by households ``remains flat'' because of slow wage growth, Ota said. Wages rose 0.2 percent last year, barely rebounding from a near decade-long slide that cut average pay by about 10 percent between 1997 and 2005.

Japan's companies, which have been enjoying the longest profit expansion in more than 30 years, are using money to increase outlays on factories and pay back debt rather than raise salaries, Ministry of Finance data show.

Today's report ``does not change the big picture,'' said Hiroshi Shiraishi, an economist at Lehman Brothers Japan Inc. in Tokyo. ``The corporate sector-driven recovery is continuing, but the income pass-through to the household sector remains subdued and upward pressure on prices remains weak.''

End of Deflation

Spending has also come under pressure from an increasing tax burden on households. The government will this year finish phasing out tax breaks introduced in 1999, adding 14,000 yen ($120) to the average annual tax bill for a family of four.

Capital spending surged 2.2 percent, today's report showed, compared with expectations for a 1.6 percent increase.

Elpida Memory Inc., Japan's sole maker of computer-memory chips, said last month it will increase production to double sales this year.

The GDP report showed signs that the economy is emerging from its tussle with falling prices. Nominal growth, which doesn't take price changes into account, grew at an annual 5 percent pace, faster than expansion in real terms and the biggest jump in more than six years.

The GDP deflator, a broad measure of price changes, fell 0.5 percent from the same quarter a year ago, the smallest drop since 2004, when poor weather caused a surge in vegetable prices.

``The end of deflation is clearly coming into sight,'' Ota said.

To contact the reporter on this story: Lily Nonomiya in Tokyo at lnonomiya@bloomberg.net

Last Updated: February 15, 2007 03:06 EST