Jan. 26 (Bloomberg) -- Japan's inflation unexpectedly slowed in December as oil prices declined, reducing prospects for an interest-rate increase when central bankers meet next month.

Core consumer prices, which exclude fresh food, rose 0.1 percent from a year earlier, the government's statistics bureau said today in Tokyo. The number was less than the 0.2 percent median estimate of 38 economists surveyed by Bloomberg News. Core prices climbed 0.2 percent in November.

Slower inflation may fuel concern that Japan has yet to overcome its seven-year bout of deflation. The Bank of Japan kept the key overnight lending rate at 0.25 percent last week in a 6-3 vote, and Governor Toshihiko Fukui said most board members cited the need to further examine prices and consumer spending.

``This doesn't take a rate decision off the table, but it'll make it more difficult for the bank to explain the need for a hike,'' said Hiroshi Shiraishi, an economist at Lehman Brothers Japan Inc. ``If we get a decent gross domestic product report in February, with solid consumption numbers, the BOJ could decide to move.''

The yen traded at 121.54 per dollar at 5:02 p.m. in Tokyo compared with 121.45 before the report was published.

The central bank raised interest rates in July for the first time in almost six years. Japan's key rate, the lowest among major economies, compares with the U.S. Federal Reserve's 5.25 percent and the European Central Bank's 3.5 percent.

Waning Expectations

Expectations for a February rate increase have waned on speculation data may not be strong enough to support higher rates and politicians could keep pressuring the bank to leave them on hold. Contracts for the exchange of overnight interest rates today showed a 40 percent chance the bank will act next month, down from 69 percent on Jan. 18, according to Credit Suisse Group.

Core prices in Tokyo, a harbinger of nationwide inflation, rose 0.2 percent in January, the same pace as December. The result matched economists' expectations.

Excluding energy as well as food, prices nationwide fell 0.3 percent in December, more than a 0.2 percent decline a month earlier, the government said.

Dubai crude, a benchmark for Asian refiners, has lost more than a quarter of its value since reaching a record $72.10 a barrel on July 17. Japan imports virtually all of its oil.

Cheaper oil is also slowing gains in wholesale prices and reducing pressure on companies to pass costs to consumers, diminishing the risk of inflation. Producer prices, the amounts companies pay for energy and raw materials, rose 2.5 percent in December from a year earlier, the slowest pace in a year.

Could Turn Negative

``The risks for Japan's consumer prices are pointed toward their decline, and it's quite possible core prices will hover near zero until the third quarter,'' said Azusa Kato, an economist at BNP Paribas Securities Japan Ltd. in Tokyo. ``With slowing inflation, the Bank of Japan faces difficulty convincing politicians and the public on the need for a rate hike.''

Bank of Japan policy maker Miyako Suda yesterday said all board members agree that ``prices will return to a rising path once the adjustment of crude oil prices is over.'' It's ``hardly conceivable'' crude oil prices will keep falling as the global economy, including the U.S., will probably keep expanding, she said in a speech in Saga, southwestern Japan.

Governor Fukui said on Jan. 18 that a slowdown in core prices because of cheaper oil wouldn't diminish the chance for a rate increase. Lower energy costs may help the economy, he said.

Deflation Persists

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 an upper house election in July. Fukui has said borrowing costs need to be raised gradually to avoid excessive business investment and asset-price bubbles.

Finance Minister Koji Omi today urged the central bank to support the economy with its monetary policy, though he added that specific policy decisions are up to the bank. Economic and Fiscal Policy Minister Hiroko Ota said deflation remains in the world's second-largest economy.

``Deflation has persisted in Japan for a long time,'' Ota told reporters in Tokyo today. ``Both the GDP deflator and CPI are hovering around zero, so we need to watch to make sure the trend isn't reversed.''

Prices excluding gasoline and one-off factors including cuts in mobile-phone charges fell 0.2 percent in December, more than a 0.1 percent drop in November, the Cabinet Office said today. Kazumasa Iwata, one of the Bank of Japan's two deputy governors, has said attention should be paid to the measure, known as ``core core'' prices, to check the real strength of inflation.

GDP Report

``Though our forecast is for inflation to trough at zero percent in February, the risk is that we see a brief period of deflation,'' said Glenn Maguire, chief Asia economist for Societe Generale in Hong Kong. ``The reality for the Bank of Japan is that it simply cannot present the case for, and the government will not countenance, a further rate hike while there is a significant risk of even the briefest flirt with deflation.''

The economy probably grew an annual 2.9 percent in the fourth quarter, according to a Bloomberg News survey of economists, accelerating from 0.8 percent in the previous three months. The government will publish the gross domestic product report on Feb. 15, six days before the central bank's next interest-rate decision is announced.

In 2006, core consumer prices rose for the first time in eight years. Prices in the year climbed 0.1 percent, the statistics bureau said.

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

Last Updated: January 26, 2007 03:08 EST