May 12 (Bloomberg) -- The Bank of Japan is focusing on the risk that the global slowdown and financial-market turbulence will hurt the economy's longest postwar expansion, Governor Masaaki Shirakawa said.

``Right now we must focus our attention on the downside risks'' to the economy, Shirakawa said today in a speech at the Japan National Press Club in Tokyo. It's ``not appropriate to predetermine the future policy direction'' because ``uncertainty about the economic outlook is high,'' he said.

The central bank last month cut its growth forecast and raised its inflation estimate in a report that omitted a call for increasing interest rates for the first time in two years. Shirakawa said the economy will probably pick up after slowing ``for some time'' and keeping interest rates ``extremely low'' could prompt companies and consumers to make excessive investments and misallocate resources.

``Governor Shirakawa probably intends to hold the key overnight lending rate at 0.5 percent through the current fiscal year, waiting for the economy's uncertainty to fade, and then raise it in the middle of the following year,'' said Hideo Kumano, a former central bank official and now chief economist at Dai-Ichi Life Research Institute.

Investors see a 34 percent chance of a rate increase by December, according to JPMorgan Chase & Co. calculations using overnight interest-rate swaps.

Slower Growth

The world's second-largest economy will grow 1.5 percent in the year ending March 2009, less than the October projection of 2.1 percent, the central bank said in the semi-annual outlook published on April 30.

``We're facing a variety of risks right now,'' Shirakawa said. ``We don't have any predetermined direction for policy now, either upside or downside,'' he added, echoing language used in the outlook. He said the so-called virtuous cycle of higher production feeding into income and spending has been weakening.

The bank is paying particular attention to the performance of overseas economies and world financial-market volatility, he said. Money markets abroad remain volatile, Shirakawa said, while adding that Japan's money market has been relatively calm.

Japan's economy probably grew an annualized 2.5 percent in the first quarter as demand from emerging markets made up for a decline in exports to the U.S., according to the median estimate of 32 economists surveyed by Bloomberg News.

`Extremely Low'

That would be slower than the 3.5 percent expansion in the final three months of 2007, though still faster than the potential growth rate, which the bank estimates at between 1.5 percent and 2 percent. Potential growth is the pace achievable when most of the country's labor and capacity is used.

``The central bank must bear in mind that real interest rates are currently near zero, which is extremely low,'' the governor said. ``Therefore the level of interest rates needs to be adjusted'' as the economy extends its expansion under stable prices, he said.

Japan's core consumer prices rose 1.2 percent in March from a year earlier, meaning the gauge of inflation exceeds the central bank's 0.5 percent benchmark interest rate, the lowest among major economies.

Core prices, which exclude fresh food, will rise 1.1 percent this fiscal year, the central bank said in the outlook. Shirakawa said prices won't deviate much from the zero to 2 percent range at which the bank considers them to be stable.

The effect of monetary policy should be judged based on an assessment of overall borrowing costs, not just the benchmark overnight rate, Shirakawa said. Long-term rates, or bond yields, tend to decline on expectations the economy will worsen, while rising inflation lowers real interest rates, he said.

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

Last Updated: May 12, 2008 02:15 EDT