(Adds meeting between BOJ and govt, market moves)
By Tetsushi Kajimoto
TOKYO, Feb 12 (Reuters) - Japanese wholesale prices fell in the year to January, the first such drop in five years and possibly signalling the second bout of deflation this decade for the world's No.2 economy as it slides into recession.
Policy-makers around the world have highlighted the threat of deflation to the global economy but Japan is seen particularly at risk, with already-weak domestic consumption under pressure from a record decline in exports.
The global financial crisis has sent much of the rich world into recession and dealt a severe blow to Japan's export-reliant economy and its factories as demand from overseas crumbles.
"Given such a rapid fall in wholesale prices, Japan will definitely fall into deflation in the coming few months," said Masamichi Adachi, a senior economist at JPMorgan Securities Japan.
"The central bank may insist it sees no signs of a deflationary spiral, but political pressure will mount for the bank to adopt unconventional steps to avoid that happening if production and demand continue to tumble and core consumer prices start to fall more than 1-2 percent from a year earlier."
Wholesale prices fell 0.2 percent in January from a year earlier, less than six months after wholesale inflation hit a 27-year peak of 7.4 percent in August on soaring oil and commodity prices. Markets had expected price to rise 0.3 percent.
Some economists blamed the fall in wholesale inflation on falls in prices of fuel and raw materials as well as a stronger yen, while analysts expect more downward pressure on prices as a weakening economy causes the output gap to widen.
"As we see weakness in corporate prices spreading to a wide range of sectors, it is also possible that consumer prices will fall into negative territory from the January data," said Takeshi Minami, chief economist at Norinchukin Research Institute.
The Bank of Japan has forecast two years of deflation in Japan and economists say it is likely to start soon, given a widening output gap as demand falls and factories lie idle.
Japanese industrial production has plunged to levels not seen since the late 1980s as exports of cars, auto parts and electronics dive.
Data due next week is expected to show Japan's economy shrank at its fastest pace since 1974 in the final three months of 2008.
Deflation risks also stalk other countries. In China, wholesale prices fell 3.3 percent in January from a year earlier and there is debate about the risks from falling prices in Europe and the United States..
Financial markets focused more on a $2 trillion rescue plan for U.S. banks unveiled on Tuesday. Markets saw the plan as disappointing and Japan's Nikkei average fell 3 percent while the yen rose as investors sought a safe haven from recession.
JOB WATCH
Japan's core annual consumer inflation, which excludes volatile fresh food prices, slowed to 0.2 percent in December, tracking sliding oil prices.
The so-called core-core index, which strips out both energy and food prices and is similar to the core index in many other countries, was flat compared with a 1.8 percent rise in core U.S. consumer inflation.
With much of the developed world seen contracting at least until the next quarter, many expect the Japanese economy to start a slow recovery only later this year.
Once the economy picks up, Japanese prices are likely to stop falling, but risks remain, economists say.
"We expect the economy to recover in 2010. But if the economy still contracts in 2010, things will be different," said Azusa Kato, an economist at BNP Paribas.
"Our survey shows companies start cutting jobs by firing staff, not by attrition, when they have losses for two years in a row. So in that case, there could be deflationary spiral."
Japanese core consumer prices fell slowly for several years from the late 1990s following the country's banking crisis.
The Bank of Japan has said it needs to be on guard against a deflationary spiral but so far BOJ Governor Masaaki Shirakawa has said consumers' inflationary expectations have not significantly changed. That means the bank does not forecast such a spiral, in which people curtail purchases because they expect prices to fall, thus prompting further price cuts.
Shirakawa met with Prime Minister Taro Aso and key members of his cabinet on Thursday to discuss financial and economic conditions ahead of a G7 finance ministers' meeting in Rome on Friday and Saturday.
Those at the meeting declined to say what had been discussed.
The spreading recession has led the BOJ to cut rates to 0.10 percent and take measures such as buying corporate debt to try to ease the financial squeeze.
Some BOJ officials have recently signalled the bank's focus will be on term interest rates -- those for lending beyond overnight funds such as for periods of three months. (Additional reporting by Hideyuki Sano and Yuzo Saeki; Editing by Michael Watson)