UPDATE 2-Japan deflation deepens, BOJ may keep funding support

(For more stories on the Japanese economy click [ID:nECONJP])

* Wholesale prices fall at a record 6.6 percent yr/yr

* Drops in commodity costs, weak demand weigh on prices

* Analysts say BOJ to prolong corporate finance support
(Adds comments, details, market moves)

By Tetsushi Kajimoto

TOKYO, July 10 (Reuters) - Japanese wholesale prices fell a
record 6.6 percent in the year to June, as the world's No.2
economy slides deeper into deflation, reinforcing the view that
the Bank of Japan will keep its corporate funding support
measures in place beyond September.

Credit conditions have eased, but debate is likely to heat up
within the BOJ over whether to prolong these special measures to
avoid sending the wrong signal to the markets as the economy
sinks deeper into deflation.

"Even though production is picking up, Japan is saddled with
huge slack in the economy, and this could pose the threat of a
deflationary spiral. The BOJ is likely to continue its current
credit easing steps to combat deflation," said Takeshi Minami,
chief economist at Norinchukin Research Institute.

The fall in the corporate goods price index was bigger than a
median market forecast for a 6.4 percent drop and followed a
revised 5.5 percent slide in the year to May, marking the sixth
straight month of annual declines.

Oil and raw materials price falls were the main culprit, but
weak domestic demand was also to blame as companies curb capital
spending and slash jobs following a record contraction in the
first quarter.

Shorter-term Japanese government bonds rose on Friday pushing
the two-year yield to a 3-1/2-year low JP2YTN=JBTC as
speculation grew that the BOJ may extend its corporate finance
support measures beyond September, although financial markets
took Friday's data in their stride. [JP/]

The BOJ has cut interest rates twice to 0.1 percent in the
wake of the global financial crisis last year and taken steps
like buying commercial paper and corporate bonds and providing
low-interest funds to banks against corporate debt as collateral.

The central bank policy board meets next Monday and Tuesday.

Japanese Economics Minister Yoshimasa Hayashi said he was
concerned about the trend in price changes but that it was too
early to say the country has returned to deflation.

"We have to manage this economy and explain our policies
carefully to make sure concerns about deflation don't become a
reality." [ID:nTKF106462]

SLIDING OFF THE PEAK

Wholesale inflation has evaporated after scaling a 27-year
peak last August, as the global financial crisis sent commodity
prices tumbling.

Reflecting weak demand at home, domestic final goods prices
dropped 2.6 percent in the year to June, the biggest decline
since 2002, pointing to further pressure on consumer prices,
which fell a record 1.1 percent in May from a year earlier.

"As jobs and income conditions deteriorate, consumers are
cutting down on spending while opting to buy low-priced goods.
This is having an impact on price trends," said Taisuke Nakamoto,
an economist at Dai-ichi Life Research Institute.

Nakamoto expected Japanese core consumer prices, which
excludes fresh food but includes oil products, to have fallen 1.7
percent in June from a year earlier.

Wholesale prices have tended to move more sharply than
consumer prices, which fell 1.1 percent in the year to May.
Consumer price data for June will come out at the end of this
month. JPCPI=ECI

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

Underlining the risk of deepening deflation and weakness in
final demand, the government estimates that supply capacity now
exceeds actual demand by 45 trillion yen ($484 billion) a year.

The Bank of Japan and private-sector economists are
forecasting at least two years of deflation.

But while opinions are divided about whether this will be
mild or a more serious slide that prompts consumers to curb
spending, the BOJ says Japan is not facing a deflationary spiral.

Japan's gross domestic product may grow a modest 0.4 percent
in April-June, after a record 3.8 percent decline in the first
quarter, a Reuters poll showed, as companies slowly build output
and government stimulus trickles down. [ID:nLG69853]

But analysts expect any recovery in Japan to be fragile as
many companies slash jobs and cut back on capital spending on
weak domestic demand.
($1=92.89 Yen)
(Editing by Hugh Lawson)