(For more stories on Japan's economy, click [ID:nECONJP]) (Adds details)
By Leika Kihara
TOKYO Jan 30 (Reuters) - Japanese industrial production fell a record 9.6 percent in December, while core annual inflation almost evaporated, reinforcing expectations of a record economic contraction as the global financial crisis worsens.
Unemployment hit a three-year high, household spending slid and manufacturers saw no quick turnaround in the outlook for industry -- the main driver of the world's second-biggest economy -- as inventories hit record highs despite factory closures and lay-offs to cut production.
The subsiding inflation and worsening economic conditions are stoking deflation worries, as in other major economies, which may prompt more central bank steps to support the staggering economy and unfreeze credit markets that are starving key companies of cash.
Economists said fourth-quarter GDP figures, due out in February, would likely show Japan's economy shrinking at an annual rate of around 10 percent -- the sharpest fall since the first oil crisis in 1974 and bigger than any during the Japanese banking crisis 10 years ago.
Tatsushi Shikano, senior economist at Mitsubishi UFJ Securities, said early 2009 also looked bleak.
"As output adjustments continue, weakness in the overall economy will persist in January-March, and the degree of worsening depends much on how exports turn out," he said.
"It is already a consensus view that core consumer inflation will turn negative soon, but we must watch if a worsening of the economy pushes Japan into a deflationary spiral even though the Bank of Japan sees no signs of that happening right now."
Japan's industrial production fell a record 9.6 percent in December, after an 8.5 percent drop in November, as companies have been forced to cut output as export demand for their cars, electronics and machinery evaporates. [JPIP1=ECI]
The sharp global slowdown has prompted Japanese chip makers to seek mergers to survive, while big carmakers like Honda Motor Co (7267.T) and Toyota Motor Corp (7203.T) slash earnings forecasts and shutter plants. [ID:nT224768] [ID:nT279044]
"We haven't experienced such a sharp fall in the past," Economics Minister Kaoru Yosano said. "This drop is likely to continue."
For a graphic on industrial output, go to:
Related fears for the health of the U.S. economy, and the effect on Japanese exports, drove the Nikkei share average .N225 down 3.1 percent, with a string of corporate profit warnings not helping. [.T]
Once again the yen's JPY= safe-haven reputation trumped the weak Japanese economic data, as it rose to around 89.3 per dollar. FXNEWS [FRX/]
INVENTORIES STILL RISING
Susumu Kato, chief economist at Calyon, said he expected a 9.6 percent annualised contraction in the fourth quarter, followed by a deeper slump in January-March.
Morgan Stanley projected an annualised 13.8 percent contraction, bigger than the previous record logged in 1974.
"We expect declines across all main demand components, led by double-digit annualised losses in capex and net exports," said Morgan Stanley chief Japan economist Takehiro Sato.
Adding to the gloom, there is no sign that production cuts have finished. Production is now at its lowest level in 20 years with spare capacity at factories at a nearly seven year high, yet inventories grew for a fourth straight month.
That suggests further production cuts ahead as manufacturers try to clear goods piling up in warehouses.
"The inventory ratio rose to a record high, showing output adjustments are still not catching up with the incredible speed of falls in shipments," said Junko Nishioka, chief economist for RBS Securities.
Factories forecast a further slide in production of 9.1 percent in January and another 4.7 percent fall in February.
Deepening woes are prompting companies to slash not just output but jobs.
Japan's jobless rate rose to 4.4 percent in December while the availability of jobs sank to a five-year low. [JPUNR=ECI]
Annual core consumer inflation slowed to 0.2 percent from 1.0 percent in November as oil prices slide, after hitting a decade high 2.4 percent. [JPCPI=ECI]
Energy prices fell 6.8 percent in December from a year earlier, a government official said.
While motorists cheer, the rapid slowdown in inflation has prompted fears of a return to deflation, which plagued Japan in the early 2000s in the wake of Japan's banking crisis.
The Bank of Japan, which forecasts deflation for two years to March 2011, has dropped interest rates to just above zero and is buying corporate debt to ease an increasingly severe funding squeeze. [ID:nT42338]
The U.S. Federal Reserve on Wednesday also kept its main interest rates unchanged, but signaled unease over deflation risks amid the weakening economy. [ID:nN28496147]