Sept. 19 (Bloomberg) -- The Bank of Japan kept interest rates unchanged after the economy shrank last quarter and the U.S. Federal Reserve cut borrowing costs to avert a recession.

Governor Toshihiko Fukui and his policy-board colleagues left the key overnight lending rate at 0.5 percent, the bank said in a statement today in Tokyo. The decision was by an 8-1 vote, with Atsushi Mizuno the sole advocate for an increase for a third consecutive meeting.

Bonds had the biggest drop in eight months as Mizuno's opposition and comments by Fukui that Japan's ``very low'' interest rates still need to be raised spurred speculation of a rate increase later this year. Fukui said the yen carry trade, where investors borrow the currency to buy higher-yielding assets overseas, shows how resources can be misallocated.

``Governor Fukui wants to prevent the flame of rate- increase expectations from burning out,'' said Yasunari Ueno, chief market economist at Mizuho Securities Japan Co. in Tokyo.

The yield on the 10-year bond rose 7 basis points to 1.6 percent. The yen traded at 115.84 per dollar at 10:21 a.m. in London from 115.92 before the announcement, which was expected by all 42 economists surveyed by Bloomberg News.

The Fed yesterday lowered its key interest rate by a half point to 4.75 percent, the first cut in four years.

No Recession

Fukui said the U.S. housing slump and resulting financial- market turmoil have increased risks for the U.S. economy, Japan's biggest export market. He added that he doesn't expect the world's largest economy to slip into recession.

The bank's board members agreed that Japan's economy is growing in line with their twice-yearly forecast made in April, Fukui said. The bank maintained its view that the economy is ``expanding moderately.''

Mizuno said last month Japan needs to raise rates to prevent the kind of excess borrowing that helped trigger the U.S. subprime mortgage crisis. Japan's short-term rate is the lowest among major economies.

``This presumably explains his vote, even though the current balance of risks should not put avoiding another bubble at the top of the agenda for Japan,'' said Richard Jerram, chief Japan economist at Macquarie Securities Ltd. in Tokyo.

Other central banks have kept borrowing costs unchanged this month as they assess whether the U.S. subprime mortgage collapse will derail global economic growth.

Other Central Banks

The European Central Bank shelved a plan to raise rates on Sept. 6, and the central banks of Australia and New Zealand also kept rates on hold. The Bank of England last week extended emergency funding to Northern Rock Plc -- the biggest bailout for a British bank in 30 years -- and yesterday offered extra cash to money markets to boost confidence in the banking system.

``Global coordination to counter the financial-market volatility is currently a top priority for central banks worldwide,'' said Jun Ishii, chief fixed-income strategist at Mitsubishi UFJ Securities Co. in Tokyo. ``The Bank of Japan's pursuit of a rate increase is already losing persuasiveness, given that GDP contracted and consumer prices keep falling.''

Gross domestic product shrank at an annual 1.2 percent pace in the second quarter, as businesses cut investment and consumer spending grew at about half the pace of the first quarter. The contraction, the biggest in four years, prompted economists to cut their growth forecasts for the year ending March 31.

Slower Growth

Nomura Securities Co. last week said the world's second- largest economy will expand 1.8 percent this fiscal year, less than its previous estimate of 2.2 percent. Goldman Sachs Group Inc. this week cut its estimate to 1.8 percent from 2.4 percent.

``The pace of economic growth is decelerating to between 1.5 percent and 2 percent, the level the central bank considers as Japan's potential growth rate,'' said Masaaki Kanno, a former central bank official and now chief economist at JPMorgan Securities Inc. in Tokyo. ``The slowdown will fuel debate on whether consumer prices will really resume rising'' as the central bank predicts.

Consumer prices excluding fresh food -- a key gauge of inflation -- slid 0.1 percent in July from a year earlier, a sixth monthly decline. Consumer prices will eventually resume rising, Fukui said.

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

Last Updated: September 19, 2007 05:22 EDT