Nov. 16 (Bloomberg) -- Bank of Japan Deputy Governor Toshiro Muto said the U.S. housing recession and financial- market turmoil could hurt Japan's economy, making it ``difficult'' to decide when to raise interest rates.

The central bank expects the economy to keep growing with stable prices, though ``we must examine both upside and downside risks carefully,'' Muto, 64, said in an interview yesterday in Tokyo. ``This is quite a difficult situation.''

Governor Toshihiko Fukui, whom Muto is favored to replace in March, this week also said the U.S. housing slump and market rout could become worse than expected, threatening global growth. Lehman Brothers Holdings Inc. today pushed back its forecast for the next increase in Japan's key rate, the lowest among major economies, from the first quarter of 2008 to the third.

``The economic views of the Bank of Japan and financial markets are converging somewhat, though the bank hasn't lowered its rate-hike flag just yet,'' said Hiroshi Shiraishi, an economist at Lehman in Tokyo. ``There won't be any major changes in the bank's policy stance should Muto become governor.''

Japanese bonds rose, pushing 10-year yields down as much as 3.5 basis points to 1.46 percent, a 21-month low. The yield was 1.47 percent at 5:47 p.m. in Tokyo. Lehman's rate-increase reassessment follows similar moves in the past month by Credit Suisse Group, Goldman Sachs Group Inc. and UBS AG.

`Fully Aware'

Muto said policy makers ``are fully aware'' growth in Japan would be threatened should the U.S. slowdown infect the rest of the world. The housing crisis and banks' reluctance to lend have yet to damp spending by U.S. consumers and companies, he added.

His comments ``reveal the Bank of Japan's true feelings,'' said Yasuhiro Onakado, chief economist at Daiwa SB Investments Ltd. in Tokyo. ``Japan's economy will continue to lose steam.''

The bank this week held the key overnight lending rate at 0.5 percent. ``Unstable'' global financial markets could derail economic growth, board members said in October, according to minutes released today.

Muto said expectations that borrowing costs will stay low for a long time could cause swings in growth and prices and encourage inefficient investment. Fukui has also said rates need to rise to deter companies and traders from making risky investments, even as barriers mount against an increase.

Fallout from the U.S. subprime-mortgage collapse has wiped $1.8 trillion from world stock markets since Oct. 31 and the yen has gained more than 4 percent, hurting Japanese exporters.

Waning Exports

Shipments to the U.S., Japan's biggest market, fell at the fastest pace in almost four years in September. At home, consumer prices have yet to rise this year and household spending is being curtailed by falling wages and a deteriorating job market.

Muto rebuffed criticism that the central bank is eager to raise rates hastily.

Policy makers ``have never said such things,'' he said. ``We have repeatedly said we'll raise interest rates in accordance with improvements in the economy and prices; we don't have any predetermined schedule.''

Japan has struggled to beat deflation that emerged after an asset-price bubble burst in the early 1990s and compelled the central bank to cut rates to near zero percent. The bank raised the key rate for the first time in almost six years in July 2006 and doubled it to 0.5 percent in February.

Lenders in Japan have also suffered from the country's low rates, as narrow spreads between interest on loans and deposits curb interest income.

Third-Quarter Growth

Recent data, including gross domestic product figures that showed the economy rebounded in the third quarter, back the bank's view that the expansion will be sustained, Muto said.

Japan's economy grew an annualized 2.6 percent last quarter after contracting 1.6 percent in the previous three months, as exports and consumer spending countered a drop in housing investment, the government said this week.

Muto said the ``severe decline'' in housing will eventually be reversed. The drop was caused by the enforcement of stricter rules for obtaining building permits and pent-up demand will be met later, he said. Muto forecasts economic growth will average about 2 percent over the two years through March 2009.

Japan's housing starts tumbled 44 percent in September after the government introduced the rules in response to a 2005 scandal involving faked earthquake-engineering data.

Core consumer prices, which exclude fresh food, are ``highly likely to enter positive territory from the end of the year or toward the beginning of next year, even if only modestly,'' Muto said.

Next Governor

Muto is most likely to become governor when Fukui's five- year term ends next March, according to 15 of 16 economists surveyed by Bloomberg News this week. He was a top Finance Ministry official before becoming one of the two deputy governors in March 2003.

The government's nominations for governor must be approved by both chambers of Parliament, giving the opposition Democratic Party of Japan, which won the most seats in the upper house in a July election, the power to block any appointment.

The DPJ disapproved of Muto's selection in 2003, citing objections to parachuting public servants into top government positions. DPJ leader Ichiro Ozawa this week said the party won't necessarily reject a government official to replace Fukui.

``The DPJ is apparently softening its stance of opposing everything the ruling party will likely propose,'' said Seiji Shiraishi, chief economist at HSBC Securities Japan Ltd. in Tokyo. ``Muto has hands-on experience at the central bank and strong networks in politics and business circles.''

Muto said his stint at the Finance Ministry has ``never influenced'' his judgment at the central bank.

``I've worked very hard to carry out the duties of my current position and I see it as a calling,'' he said. ``I will serve the rest of my term with the same determination.''

To contact the reporters on this story: Mayumi Otsuma in Tokyo at motsuma@bloomberg.net; Masahiro Hidaka in Tokyo at mhidaka@bloomberg.net

Last Updated: November 16, 2007 03:55 EST