* Japan May core consumer prices fall 1.1 pct from year ago
* Analysts say BOJ may mull extending fund-support steps
* Falling demand increasing factor alongside commodity prices
* Finance minister: will do utmost to avoid deflation spiral (Recasts headline)
By Stanley White
TOKYO, June 26 (Reuters) - Japanese consumer prices fell a record 1.1 percent in the year to May, with growing signs of falling demand pushing the economy deep into its second spell of deflation this decade, which may warrant a central bank response.
The numbers released on Friday are another sign of weakness in Japan's economy, and may mean the Bank of Japan extends support for the corporate finance market beyond their September expiry date, but not return to the policy of full-blown quantitative easing, analysts said.
The plunge in core CPI, which includes energy prices, was driven at least in part by the 70 percent decline in oil prices between July and October last year. It was the biggest drop since CPI records began in 1970, but smaller than analysts' forecast of 1.2 percent.
There was also clear evidence of evaporating demand pushing down prices.
The so-called core-core inflation index fell 0.5 percent from a year earlier, the biggest decline in almost two years. This measure strips out both energy and food prices and is similar to the underlying inflation gauges used in Europe and North America.
The general services index, more exposed to consumer demand that input costs, fell 1.1 percent.
"I'd say about half of the fall in the core-core index is driven by weakness in demand. The fact that the prices of general services posted a year-on-year fall in May also highlights soft consumer demand," said Junko Nishioka, chief economist at RBS Securities.
"We expect pressure on prices from weak domestic demand to strengthen and to peak around year-end."
Core consumer prices for Tokyo, available a month before the nationwide data, fell 1.3 percent in June from a year earlier, the fastest pace of decline in eight years and more than a median market forecast of a 1.1 percent decline.
"We'll closely watch price trends and carefully manage the economy to prevent it from worsening further and keep it from falling into a deflationary spiral," Finance minister Kaoru Yosano told reporters.
Having just emerged from almost a decade of deflation after the collapse of a property bubble in the 1990s, the economy has been sideswiped by the global financial crisis that started in 2007 with a U.S. mortgage market meltdown.
The central bank is forecasting two years of deflation, so declining prices alone are unlikely to push it back into full-blown quantitative easing, which in Japan involved flooding the banking system with cash to meet a specific monetary target.
But the bank is already engaged in quantitative easing in the sense that it is expanding its balance sheet. It has ramped up its buying of government bonds twice since December, effectively capping bond yields and borrowing costs, as the financial crisis ripped through global markets.
"Even with deflation going further, as long as the real economy is on an uptrend, I think the BOJ will not activate quantitative easing," said Masamichi Adachi, senior economist at JP Morgan.
"The Japanese fiscal situation is much worse than the U.S., on the debt side at least, and if the central bank were to do something radical, that would definitely threaten the risk premium of the long-term yield."
Expectations that the world's no. 2 economy will start growing again after four straight quarters of contraction had prompted speculation that the BOJ may think about phasing out emergency steps introduced in the midst of the global financial turmoil to support corporate finance.
But earlier this week, BOJ policy board member Seiji Nakamura said that judging from current severe corporate funding conditions it was too early to let central bank measures aimed at easing credit strains expire as scheduled in September.
The BOJ currently expects core CPI to fall 1.5 percent in the year to March 2010 and to decline 1.0 percent in fiscal 2010/11.
Analysts expect deflation to accelerate in coming months as slack household consumption also forces companies to cut prices. This hurts the economy as falling prices cause consumers and businesses to delay purchases, dragging the economy down further.
But the Organisation for Economic Co-operation and Development made clear that ending the BOJ's unconventional measures, such as buying commercial paper and corporate debt from banks, any time soon would be premature and recommended maintaining "effective quantitative measures" until inflation returns. (Editing by Hugh Lawson)