Jan. 22 (Bloomberg) -- The Bank of Japan kept its benchmark interest rate at 0.5 percent and said economic growth was slower than forecast, stoking speculation borrowing costs may be cut this year.

Growth in the year ending March 31 will be ``slightly lower'' than the potential rate of 1.5 percent to 2 percent, the bank said, citing a decline in housing investment. The expansion will probably pick up to just above potential next year, it said.

Japan's Nikkei 225 Stock Average plunged, completing its worst two-day drop in 17 years on concern global growth is faltering. The chances of a rate cut by July became better than even today, as investors see policy makers backtracking from a pledge to gradually raise borrowing costs that have been below 1 percent for more than a decade.

``The BOJ expressed concerns over slowing growth given the current turmoil in the financial markets,'' said Soichi Okuda, chief economist at Sumitomo Research Institute in Tokyo. ``That may fuel speculation a rate cut could be on the cards.''

The yen traded at 105.85 per dollar at 5:09 p.m. in Tokyo from 106.23 before the interest-rate announcement. The Nikkei 225 slid 5.7 percent. The yield on Japan's 10-year bond fell 4.5 basis points to 1.315 percent as investors sought the relative security of government debt.

`Delicate Stage'

Governor Toshihiko Fukui said the central bank retains its basic policy of gradually raising rates as the economy expands, while acknowledging that the policy board is at a ``delicate stage'' in judging the economic and price situation.

``In order to conduct monetary policy appropriately, we need to be forward looking,'' Fukui said at a press briefing in Tokyo after being asked for comment on the speculation of a cut.

Investors now see a 76 percent chance the bank will reduce the benchmark rate by July, according to calculations by JPMorgan Chase & Co. using overnight interest-rate swaps.

``If the U.S. housing market slump causes a serious credit crunch and pushes the country's economy into a recession, the Bank of Japan may face calls for a rate cut from the Japanese government and businesses,'' said Akio Makabe, a professor of economics at Shinshu University.

The policy board today stopped short of providing numerical revisions to its growth projections made in October. The bank said in October that the economy will expand 1.8 percent in the current fiscal year and 2.1 percent the following period. Policy makers check the economy's performance compared with their semiannual forecasts every January and July.

Housing Starts

The government cut its growth forecast for this fiscal year to 1.3 percent from 2.1 percent after stricter building-permit rules caused housing starts to tumble to a four-decade low.

The central bank last month lowered its assessment of the economy for the first time in three years. Managers of the bank's branches nationwide last week said conditions were worsening in four of Japan's nine regions as housing investment declined and small businesses struggled to pass rising costs on to clients.

Oil and food costs, rather than consumer demand, caused inflation to quicken to the fastest pace in almost a decade in November. Consumer prices excluding fresh food rose 0.4 percent from a year earlier, while wages have fallen for nine of the past 11 months.

Fukui told parliament this month that higher costs may squeeze profits and slow growth while also lifting consumer prices higher, making policy decisions difficult.

Still, policy makers today confirmed that they expect growth to pick up in the year starting April 1.

`Virtuous Cycle'

``With a virtuous cycle of growth in production, income, and spending remaining basically intact, in fiscal 2008 the rate of real GDP growth is likely to be broadly as projected,'' the central bank said.

Most analysts still expect the bank to stick to its policy of raising borrowing costs. Nineteen of 30 economists surveyed said there is a chance of a rate increase in 2008.

There are two reasons why the Bank of Japan won't lower rates, according to Takuji Okubo, senior economist at Merrill Lynch & Co. in Tokyo.

``The economy's not going into recession,'' Okubo said. ``They have only 50 basis points to cut, so what's the point?''

Fukui reiterated last week that rates need to be lifted gradually as long as the economy expands as expected. He and other policy makers have said keeping them low for too long could encourage overinvestment and make growth unsustainable.

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

Last Updated: January 22, 2008 03:09 EST