UPDATE 3-Japan price gauge up 1st time since 2008, trend still weak

* April core CPI up 0.6 pct on year as expected

* Core-core nationwide prices down 0.1 pct

* April retail sales down 4.8 pct yr/yr, less than expected (Adds details, economist's quote, economy minister)

By Stanley White

TOKYO, May 27 (Reuters) - Japan's main price gauge rose in April for the first time in more than two years but underlying prices and consumption remained weak following the March earthquake, signalling Tokyo still has a long way to go in its battle with deflation.

Core consumer prices rose 0.6 percent in the year to April, mainly because the effect of school tuition fee subsidies dropped out of the annual comparison, while rising commodity costs also contributed to the rise. It was the first rise since December 2008 and matched the median market forecast.

Core consumer prices, which include oil products but exclude volatile prices of fresh food products, are likely to continue to edge upward due to high oil prices, in line with Bank of Japan forecasts issued last month.

Economists said the rise in the headline price gauge did not mean Japan was about to escape from nagging deflation, which squeezes profit margins as consumers constantly search for cheaper goods. They argue that wages and the labour market may not support sustained demand beyond any boost from rebuilding the country's battered northeast coast.

"Despite the CPI rising, I think Japan still remains in a deflationary environment, and particularly the labour market is still weak and corporations are not hiring," said Takuji Okubo, chief Japan economist at Societe Generale Corporate & Investment Banking.

Economics Minister Kaoru Yosano also played down the rise in the headline index saying such a move in prices could not be called inflationary.[ID:nT9E7GB04D]

RETAIL SALES DIP LESS THAN FEARED

The central bank expects the economy to recover later in the year and over the long term has linked its exit from ultra-easy monetary policy to a lasting return to moderate price increases.

But it has stressed that price rises had to reflect healthier demand and economic growth rather than rising costs, which work to dampen economic activity.

Japanese retail sales fell 4.8 percent in April from a year earlier but the drop was smaller than expected and the pace of decline slowed from the previous month, separate government data showed, boding well for a post-quake recovery later in the year.

"After the quake, rather than seeing a big drop in demand, we are seeing constraints in supply capacity, and that is best seen in exports. The consumption level is still lower than where it was before the quake, but it is already sharply up in April compared to March," said Societe Generale's Okubo.

The so-called core-core inflation index, which excludes food and energy prices and is similar to the core index used in the United States, fell 0.1 percent in the year to April after a 0.7 percent annual decline in March.

Core consumer prices in Tokyo, released a month before the nationwide data, rose 0.1 percent in the year to May, slightly slower than forecast.

A government policy to subsidise school tuition fees is no longer distorting annual changes in prices, as more than a year has passed since the policy was introduced. The move was estimated to have pushed down overall prices by about 0.5 percent.

The 9.0 magnitude earthquake and subsequent tsunami have pushed Japan into recession and led to a surprisingly deep 0.9 percent contraction in January-March, with analysts expecting the economy to shrink again in the second quarter as supply chain disruptions and power shortages hit factory output.

Japanese exports tumbled immediately after the natural disaster, but the pace of decline started to slow in April compared with the previous month, offering hope that the economy can resume growing in the third quarter as companies steadily restore output. (Additional reporting by Kaori Kaneko and Rie Ishiguro; Writing by Tomasz Janowski; Editing by Edmund Klamann)