Sept. 15 (Bloomberg) -- Japan's government said consumer spending and the service sector are showing signs of slowing, suggesting the economy may not be growing fast enough to withstand another increase in interest rates this year.

``Growth in consumer spending has been slowing recently,'' the Cabinet Office said in its September report today in Tokyo. The government left its assessment of the economy unchanged, saying it's ``recovering'' after three recessions in 15 years.

Japan's economic growth cooled in the second quarter, as exports rose at the slowest pace in more than a year. The government deleted a reference to deflation from the report's assessment of prices, and government ministers reiterated that the country's seven-year battle with falling prices isn't over.

``Government officials' comments suggest Japanese economic expansion is already slowing,'' said Yuji Saito, a senior currency dealer in Tokyo at Societe Generale SA. ``The Bank of Japan won't be able to raise rates this year.''

The yen traded at 117.68 against the dollar at 4:42 p.m. in Tokyo, compared with 117.59 late in New York yesterday.

The government downgraded its assessment of consumer spending for the first time since February 2005, in part because of a long rainy season.

Retail sales slid 1.7 percent in July and household spending, which has declined every month this year, dropped 1.3 percent, government reports showed last month. Other surveys showed industrial production unexpectedly fell in July and machinery orders had the biggest drop in almost 20 years.

`In Line'

The reports aren't a cause for concern, according to central bank board member Atsushi Mizuno.

``Things are in line with our scenario'' that prices are rising and the economy is expanding, Mizuno said on Sept. 12. ``I want to emphasize that that means fine adjustments will continue to be made to interest rates.''

Demand for services including retailing and communications slipped 0.2 percent in July because of the prolonged rainy season, the trade ministry's tertiary index report showed today.

Bank of Japan Governor Toshihiko Fukui has said the driver of Japan's economic growth will gradually shift from corporate to consumer spending. Although bad weather may have caused a temporary slowdown, the trend in household spending is ``positive,'' he said last week.

The central bank raised interest rates for the first time in almost six years in July on signs the economy had emerged from deflation. Today's report said the government aims to ``secure a stable trend in prices,'' changing the wording from ``securing the end of deflation.''

`One Step Closer'

Core consumer prices rose 0.2 percent in July, the second month of gains. Chief Cabinet Secretary Shinzo Abe today said the government must ensure prices don't resume falling, and Economic and Fiscal Policy Minister Kaoru Yosano said recent increases aren't enough to say deflation is over yet.

``The fact that prices are no longer continuously falling doesn't indicate that the economy has escaped deflation,'' Yosano said at a regular news conference in Tokyo today. Improvements in domestic demand suggest ``we are one step closer than a month earlier'' to declaring deflation's end, he added.

The Bank of Japan must ensure it raises borrowing costs gradually to avoid a relapse into deflation, the International Monetary Fund said in its World Economic Outlook report released yesterday.

The central bank ``needs to carefully balance the risks of a return to deflation against those of the possibility of accelerating inflation,'' the IMF said.

U.S. Slowdown

Today's Cabinet Office report cited concern about the impact of a slowing U.S. economy as well as high energy costs.

``There are some concerns from foreign factors such as crude oil prices and that outlook of the U.S. economy,'' the government said. Japan imports almost all its petroleum.

Economic growth in the U.S., the destination of more than a fifth of Japan's exports, slowed to an annual 2.9 percent pace in the second quarter from 5.6 percent in the first.

The IMF also said slower U.S. growth and higher oil prices are risks for the Japanese economy. Growth sustained by consumers and companies will help the economy expand 2.7 percent this year and 2.1 percent in 2007, the fund forecast in the outlook report.

Japan's economy grew at a 1 percent annual pace in the three months ended June 30, the Cabinet Office said on Sept. 11, slower than the 3.3 percent growth in the first quarter.

The current expansion will become the longest since World War II if it continues through November, surpassing the so-called Izanagi boom of 1965-1970, a 57-month period of growth named after a Japanese god.

To contact the reporter on this story: Hiroshi Suzuki in Tokyo at Hsuzuki5@bloomberg.net

Last Updated: September 15, 2006 03:44 EDT