By Leika Kihara and Makiko Yamazaki

TOKYO (Reuters) -The Bank of Japan kept interest rates steady on Tuesday and decided to decelerate the pace of its balance sheet drawdown next year, signaling its preference to move cautiously in removing remnants of its massive, decade-long stimulus.

Escalating Middle East tensions and U.S. tariffs are complicating the BOJ's task of raising still-low interest rates and reducing a balance sheet that has ballooned to roughly the size of Japan's economy.

BOJ Governor Kazuo Ueda said rising oil prices, if they persist, could affect underlying inflation in a way that could warrant action.

But he said there were bigger downside risks to Japan's economic and price outlook from uncertainty over U.S. trade policy, suggesting the bank would be in no rush to hike rates again.

"The fallout from trade uncertainty could weigh on companies' winter bonus payments and wage negotiations (with unions) next year," Ueda told a news conference, stressing the need to await more data in deciding the next rate-hike timing.

"Even if developments surrounding U.S. trade policy stabilise toward a certain direction, there's very high uncertainty on how that could affect the economy."

In a widely expected move, the BOJ maintained short-term interest rates at 0.5% by a unanimous vote at its two-day policy meeting that ended on Tuesday.

The central bank made no changes to an existing bond tapering plan, under which it will reduce government bond purchases by 400 billion yen ($2.76 billion) per quarter so that monthly buying slows to around 3 trillion yen by March 2026.

However, in an extended quantitative tightening (QT) plan decided on Tuesday, the BOJ will halve the quarterly reduction amount from fiscal 2026 so that monthly purchases fall to around 2 trillion yen by March 2027. That pace aligns with requests the BOJ received from several market players in meetings last month.

Hawkish board member Naoki Tamura dissented on that particular decision, calling instead to keep reducing purchases by 400 billion yen per quarter during fiscal 2026.

The slower balance sheet drawdown signals the BOJ's concerns about disrupting markets in the wake of last month's spike in super-long government bond yields.

While the move would delay progress in reducing the BOJ's huge balance sheet, it would put less stress on a market long dominated by the central bank's huge presence.

"Today's decision is market friendly," said Saisuke Sakai, senior economist at Mizuho Research & Technologies in Tokyo. "Slowing the pace of tapering would work to keep long-term rates from rising too much."