* Wholesale price tumble largely due to lower energy costs
* Weak final demand playing an increasing part in price falls (Adds analyst comment, details)
By Stanley White
TOKYO, Aug 12 (Reuters) - Japanese wholesale prices fell a record 8.5 percent in the year to July, highlighting growing deflationary pressure in the economy and limiting the Bank of Japan's scope for ending its unorthodox policy measures.
Although the price slide is likely to moderate in the autumn as the effect of last summer's spike in oil prices wears off, economists say weak domestic demand means wholesale price declines could persist. That could translate into lower consumer prices, prolonging the country's second bout of deflation in less than a decade.
Final goods prices, a component of the wholesale price index that loosely tracks consumer price moves, dropped an annual 3.3 percent, accelerating from June's 2.6 percent fall.
"We're going to see increasing downward price pressure from weak demand," said Takeshi Minami, chief economist at Norinchukin Research Institute.
"The Bank of Japan has said the country is not entering a deflationary spiral, so it won't ease monetary policy further. But as long as weakness in the economy and prices persists, it won't be able to raise rates either. The bank will keep interest rates on hold at least until March 2011," Minami said.
The BOJ already expects two years of deflation, so mild price falls would not push it to return to 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 central bank will probably forecast deflation stretching out for three years to March 2012 when it releases its twice-yearly outlook report in October, sources told Reuters.
The fall in the corporate goods price index (CGPI) was slightly smaller than a median market forecast for an 8.7 percent drop but much bigger than a revised 6.7 percent drop in June.
The slide was due in large part to oil prices more than halving from their record highs near $150 per barrel in July last year.
But lower prices for steel, chemicals, nonferrous metals and scrap metal from a year earlier also weighed on wholesale prices, a BOJ official told reporters at a briefing.
PRICE TREND STILL WEAK
Japanese government bond futures rose 0.14 point to 137.34, rebounding from a seven-week low hit on Monday as major stock markets fell due to doubts about the strength of the global economic recovery.
The CGPI data for July offered evidence that the pace of wholesale price declines could ease provided the global economy continues to recover.
Compared to the previous month, CGPI rose 0.4 percent, the first gain in almost a year and better than a median estimate for a flat reading, as a rebound in overseas economies lent some support to prices of energy and chemicals, a BOJ official said.
But excluding overseas demand, the trend for prices in Japan is still weak, economists say.
"The pace of wholesale prices may slow, but this will still lead to declines in consumer prices, because domestically there is no reason for prices to spike," said Masamichi Adachi, a senior economist at JPMorgan.
"If you're a Japanese company, you will look at your inventories, look at your competitors, and then you will probably end up cutting prices."
Furthermore, this weakness in the economy could add to deflationary pressure as companies curb capital spending and cut jobs, providing little reason for the central bank to end its unconventional measures aimed at easing corporate funding strains.
BOJ Governor Masaaki Shirakawa said on Tuesday that downward price pressure could persist as the global economy suffers the aftershock of a severe recession. He said he was unsure how strong final demand would be after the effects of government stimulus measures taken worldwide fade.
The BOJ decided last month to extend its unconventional easing measures, such as buying of commercial paper and offering fixed-rate funding, until December. On Tuesday its board voted to keep its benchmark interest rate on hold at 0.1 percent.
Many investors and economists expect the central bank to keep the measures in place beyond December as a safety net for corporate finance due to uncertainty over the economic outlook.
The Japanese economy is thought to have put the worst of the global economic storm behind it, with gross domestic product data due next week expected to show a 1.0 percent rise in April-June after four straight quarters of contraction. (Editing by Michael Watson)