April 27 (Bloomberg) -- The Bank of Japan slashed its inflation forecast close to zero and kept the benchmark interest rate unchanged, saying prices will take another year to accelerate.

Core consumer prices will rise 0.1 percent in the 12 months ending March 2008 and 0.5 percent the following year, the central bank said in Tokyo today in its semi-annual outlook. Policy makers had previously predicted a 0.5 percent inflation rate this year.

Stalling consumer prices will make it harder for the Bank of Japan to raise its 0.5 percent overnight lending rate to prevent excessive business investment. The cheapest official borrowing cost among major economies has driven the yen to a record low against the euro and high-yielding currencies.

``Consumer price data damped any speculation the Bank of Japan will bring forward an interest-rate increase,'' said Koji Fukaya, senior currency strategist in Tokyo at Deutsche Securities, adding that rates will be on hold until August. ``That's a bad development for the yen.''

Core consumer prices, which exclude fresh food, declined 0.3 percent in March from a year earlier, the government statistics bureau said today, the second straight monthly drop.

Other government reports today showed factory output unexpectedly slumped 0.6 percent, retail sales declined for a sixth month, this time by 0.7 percent, and household spending rose a less-than-expected 0.1 percent. The unemployment rate held at a nine-year low of 4 percent.

`Weak' Reports

``These reports were weak,'' said Hiroaki Muto, a senior economist at Sumitomo Mitsui Asset Management Co. in Tokyo. ``While the declines in prices may moderate, they're still going to be in negative territory for some time, making the hurdle for the Bank of Japan to raise rates very high.''

Economists surveyed by Bloomberg had estimated consumer prices would fall 0.2 percent in March and industrial production would surge 0.9 percent. Prices in March dropped at the fastest pace in two years. For the year ended March 31, nationwide core prices rose 0.1 percent, a second year of gains.

The government has yet to declare an end to the deflation that has plagued the economy since an asset-price bubble burst in the early 1990s, leaving companies with excess workers, debt and production capacity.

Economic and Fiscal Policy Minister Hiroko Ota said today's consumer-price report ``doesn't change my view that the end of deflation is in sight.'' Still, she added, ``we need to keep monitoring prices'' to ensure the economy emerges from deflation.

Growth Forecasts

The yield on Japan's 10-year bond fell 3.5 basis points to 1.615 percent. The Nikkei 225 Stock Average fell 0.2 percent. The yen traded at 119.48 per dollar at 10:37 a.m. in London compared with 119.54 before the rate decision, and was 162.68 against the euro after weakening to a record 162.84.

The world's second-largest economy will expand 2.1 percent both in the current fiscal year ending March 31 and the following 12 months, BOJ policy makers predicted in today's outlook report.

The central bank said it will gradually raise rates in accordance with improvements in the economy and prices, while acknowledging that the pace of increases has been slow because of ``weak'' inflation. The bank raised the key rate for the first time in almost six years last July and doubled it in February.

``Rate adjustments need to be made if the economy's expansionary trend remains intact and price trends in the long term are expected to be firm, even if prices are falling in the short term,'' Governor Fukui told reporters today.

Fukui said the central bank has no predetermined schedule for the timing or pace of rate increases. The bank will keep rates at ``very low levels for some time,'' he said.

Land Prices

Price gains will gradually accelerate as long as the economy expands at the projected pace, which exceeds its potential growth rate, Fukui said.

Keep interest rates low regardless of the economy's expansion could encourage overinvestment and hamper sustainable growth in the long run, the bank said in today's report.

``Recent developments in asset prices, as seen in the increasingly distinct upward trend for land prices in major cities, may also cause such activity to accelerate,'' it said.

Commercial land prices in Tokyo, Osaka and Nagoya jumped 8.9 percent last year, with values in some parts of the capital soaring as much as 46 percent.

``The BOJ continues to refer to the longer-term risks, with a clear reference to land prices,'' said Richard Jerram, chief Japan economist at Macquarie Securities Ltd. in Tokyo. ``There is a clear implication that it believes policy is too loose and so we should expect further interest rate increases. The BOJ seems remarkably relaxed about the fact that prices are falling again.''

U.S. Slowdown

The Bank of Japan remained upbeat on the U.S. economy, saying ``ongoing adjustments in the housing market have not so far spilled over into the wider economy, as evidenced by continued firmness in private consumption.''

The U.S. economy expanded an annual 1.8 percent last quarter, economists predict, the weakest pace in more than a year, depressed by the longest homebuilding slump in a generation. The Commerce Department will report the GDP data today.

Production by Japanese manufacturers fell 1.4 percent in the first quarter from the last three months of 2006, the trade ministry said, indicating companies are concerned that global demand will slow as the U.S. economy stalls. Exports to the U.S., a destination of a fifth of Japanese goods shipped overseas, rose at the slowest pace in more than two years last month.

``It will be hard for the Bank of Japan to raise rates as long as the outlook for U.S. growth remains uncertain,'' said Akio Makabe, professor of economics at Shinshu University.

To contact the reporters on this story: Mayumi Otsuma in Tokyo at motsuma@bloomberg.net; Lily Nonomiya in Tokyo at lnonomiya@bloomberg.net

Last Updated: April 27, 2007 05:40 EDT