UPDATE 1-BOJ to lift rates slowly, economy to benefit-Fukui

(Recasts with more comments)

TOKYO, Feb 22 (Reuters) - Bank of Japan (BOJ) Governor Toshihiko Fukui said on Thursday the central bank would keep raising interest rates gradually so that the economy will ultimately benefit from an appropriate allocation of resources.

Speaking just a day after the central bank raised the key overnight call rate by a quarter percentage point to 0.5 percent, Fukui expressed confidence that a favourable economic mechanism will remain intact even if prices fall temporarily.

Japanese interest rates are still the lowest among industrialised nations. Until last year, interest rates were virtually zero in the world's second-largest economy after years of deflation and an economic slump.

Fukui said the BOJ will fully support Japan's efforts to boost its potential growth rate, which is currently seen around 1.5 percent, while trying to reduce any risks of economic swings.

"In order to boost potential growth and make it real, we need to make sure interest rates will function to allocate funds and resources appropriately. That is the BOJ's most important responsibility," Fukui told a parliamentary committee.

"We will keep supporting the economy by creating accommodative monetary conditions with very low rates for a while. But gradually, we need to raise rates as much as possible to make sure the function of interest rates strengthens," he added.

"We are starting to walk on this delicate path with a difficult balance."

There was limited market reaction to Fukui's comments.

Fukui reiterated that the Japanese economy would likely keep expanding steadily, albeit at a moderate pace.

Data showed last week that growth accelerated to an annualised 4.8 percent in October-December from 0.3 percent in the previous quarter, thanks to a rise in personal consumption.

But there has been scant evidence of inflation after seven years of debilitating deflation. Core consumer prices, which exclude volatile fresh food prices, in December were just 0.1 percent higher than a year earlier.

Fukui acknowledged the possibility that consumer prices could fall into negative territory in the immediate future due to recent falls in oil prices.

But he also said the virtuous mechanism in production, income and spending would not be hurt even if prices fall temporarily.

At a news conference after the crucial rate decision on Wednesday, Fukui said the BOJ would raise rates slowly but had no schedules for future rate hikes in mind.

Such comments prompted the yen to fall further despite the rate hike. On Thursday, the yen tumbled to a record low against the euro and fell against the dollar.

Japan's ultra-low rates have encouraged players to use the yen as source of cheap funds to buy higher-yielding currencies in the carry trade and have prompted many domestic investors to seek better returns abroad.

Financial markets expect the BOJ to take time before moving again.

A Reuters survey of 59 market participants, conducted after the BOJ decision, showed 25 expect the BOJ to boost the overnight call rate to 0.75 percent in the July-September quarter while 26 see the second hike in last three months of this year.

This week's rate rise marks the third major policy move in less than a year.

Last March, the BOJ ended its so-called quantitative easing policy of pumping excess money into the banking system. In July it followed up with a rate rise to 0.25 percent from virtually zero, the first rate increase in six years.