'Economic growth has been sluggish against the backdrop of high energy and material prices and weaker growth in exports,' the central bank said in a statement, as it decided unanimously yesterday to keep interest rates on hold at 0.5 per cent.

The central bank's assessment was even more cautious than the one it made last month, when it cut its assessment to say economic growth was slowing further due to high energy and raw material costs.

Data released since then showed that the world's second-largest economy shrank in the second quarter, as crumbling US and European export markets hit factories, and consumers tightened belts to cope with high food and fuel costs.

That contraction was the biggest in seven years and probably ended Japan's longest expansion since World War II.

Exports to Asian emerging markets weakened in June from a year earlier after sustaining growth in the face of a slump in US and European demand.

Industrial output has fallen for two straight quarters - a harbinger of Japanese recessions for 50 years.

BOJ governor Masaaki Shirakawa said yesterday that Japan's basic economic mechanism was unchanged despite the central bank's downgrade in its economic assessment for this month.

He said the bank's board members felt the recovery in the economy might be slightly delayed.

The bank, however, does not expect a sharp downturn in the economy, as Japan does not have major excesses in facilities, debts or employment.

While a shrinking economy is its main focus, the BOJ is on guard against rising prices.

'The BOJ has lowered its forecast for the growth rate and raised its forecast for prices, but that is not a situation that can be described as stagflation. We don't see such a possibility as high at the moment,' Mr Shirakawa said.

Annual core consumer inflation hit a decade-high 1.9 per cent in June due to the surging cost of food and fuel.

Details of the BOJ's economic assessment will be realised by the central bank in a monthly economic report set to be released today.

The scale of the worldwide slump triggered by a meltdown in US mortgages last year is driving trading in global foreign exchange markets.

The US dollar has rallied to its highest in seven months against an index of major currencies on bets that Europe and Asia will suffer more than investors have previously expected.

The BOJ's task, however, is less complicated than that of the European Central Bank or the US Federal Reserve, as rises in energy and food prices have not fed through into wages and other costs.

The BOJ said in the statement it would conduct monetary policy flexibly while examining risks in both directions. -- REUTERS