UPDATE 5-Japan machinery orders slide as deflation deepens

* Core machinery orders fall more than expected to record low

* Pace of decline easing but weak capital spending persists

* Annual wholesale price decline matches record

* Weak demand increasingly weighing on wholesale prices (Adds details in paragraph 7)

By Tetsushi Kajimoto and Stanley White

TOKYO, Sept 10 (Reuters) - Japan's core machinery orders hit a record low in July, in a sign capital spending may stay weak in coming months and drag on the world's No.2 economy as it crawls out of its deepest postwar recession.

Wholesale prices also matched a record fall in the year to August, pointing to deepening deflation that could force the Bank of Japan to keep its ultra-easy monetary policy in place for a long time to come.

The 9.3 percent fall in core machinery orders, a volatile figure seen as a leading gauge of capital spending, was more than double the median market forecast for a 3.5 percent decrease from June, when orders rose for the first time in four months.

"The fall is partly a reaction to last month's increase, but the trend is weak as a whole. Capital spending probably won't recover for the rest of this fiscal year," which ends in March 2010, said Takeshi Minami, chief economist at Norinchukin Research Institute.

For a graphic of machinery orders and capacity utilisation, click here

The sharp drop in core orders was due largely to an 86 percent drop in nonferrous metals, which had soared the month before, leading to a 9.7 percent jump in core orders that month.

Core orders tend to swing sharply due to such factors, but the overall pace of decline has been moderating this year. A three-month moving average of core orders showed a fall of 1.2 percent in July, much less than the trough of minus 6.9 percent hit last December.

Still, analysts said a range of manufacturing sectors including steel, general machinery, metal products and chemicals all contributed to the slide in core orders, suggesting many firms saddled with excess capacity are unlikely to raise capital spending anytime soon.

Many Japanese firms are cautious on the outlook for final demand because the boost from stimulus spending on the ongoing economic recovery is expected to peter out early next year.

DEFLATION

The weakness in the economy could increase deflationary pressure as firms cut spending and jobs, adding to the policy challenge for the Democratic Party, which takes over the government next week after a landslide election win. [ID:nPOLJP]

The BOJ is already forecasting two years of deflation and is likely to extend that to three when it issues its twice-yearly economic outlook report in October. [ID:nT347265]

Mild price falls won't push it back into full-blown quantitative easing, in which it flooded the banking system with cash to meet a specific monetary target. But if deflation persists longer than expected it could delay the BOJ's exit from very low interest rates.

"The BOJ sees deepening deflation only as a risk now. But when it becomes its main scenario, the BOJ will need to come up with new steps to help ease monetary conditions, such as increasing the amount of its government bond buying," said Junko Nishioka, chief economist for Japan at the Royal Bank of Scotland.

The BOJ decided in July to extend a raft of measures to support corporate finance to December from their planned expiry in September. A Reuters poll showed the BOJ likely to keep rates steady at 0.1 percent at least until March 2011. [ID:nLAG003674]

The fall in wholesale prices, as measured by the corporate goods price index, was slightly larger than a median market forecast for an 8.4 percent drop. It matched an 8.5 percent annual drop in July, which is the biggest decline on record.

For a graphic of Japan's wholesale and core consumer prices, click here

Price falls are likely to ease later this year as the effect of the slide in oil prices from record levels last year fades.

But economists expect deflation to persist with weak final demand playing an increasing part in pushing down prices.

The overall final goods prices, or the prices of finished products charged to businesses, fell 5.1 percent from a year earlier in August. Domestic final goods prices, which loosely track the consumer price index, dropped 3.6 percent.

Looking at the month-on-month trend for commodities, prices of some raw materials are starting to rise due to the gradual global recovery, a BOJ official told reporters at a briefing.

But food, electronics and other finished goods prices are falling steadily, reflecting weak demand in Japan, he said.

Wholesale prices were flat in August from the previous month after a 0.4 percent rise in July.

Revised figures on Friday are expected to confirm that while Japan's economy emerged in April-June from its worst recession since World War Two, recovery will be slow and far from assured as much of it depends on stimulus measures. [ID:nT235879] (Editing by Hugh Lawson)