* Fujii scales back rhetoric in support of strong currency
* Comments spark brief slide in yen against dollar
* Repeats never said Tokyo would accept excessive yen rises
* Annual core CPI fall hits record, deflation deepens (Adds comments from Gyohten)
By Leika Kihara and Stanley White
TOKYO, Sept 29 (Reuters) - Japan's finance minister raised the prospect of currency market intervention for the first time on Tuesday in a scramble to limit the damage from a yen rally fuelled by earlier comments that he favoured a strong currency.
The yen hit an eight-month high of 88.22 to the dollar on Monday after Fujii, who has been on the job for two weeks, repeatedly said that he wanted to avoid intervention and that a strong yen would eventually support domestic demand.
It has since pulled back to around 90.00, giving up all of the previous day's gains, as Fujii backpedalled on his remarks.
Domestic demand is collapsing in the world's second-largest economy, pushing the country into its deepest deflation on record in August. Governments fighting deflation typically devalue their currencies.
"Perhaps Fujii didn't realise how much the market would move on his comments after he became finance minister. But now he realises that this isn't such a good thing," said Tokichi Ito, deputy general manager of the foreign exchange team at Trust & Custody Services Bank in Tokyo.
"I doubt Fujii has abandoned his view that a strong yen is good for domestic demand, and this view is shared by the government. But the yen buying in reaction to the government's stance has likely run its course."
A strong yen puts pressure on import prices in a country where deflation is already at record levels, although policymakers and businesses tend to worry more about the impact it has on exports, the key driver of the country's growth.
Fujii reiterated on Tuesday that global competition to devalue currencies was wrong, but that this didn't mean Tokyo would leave excessive yen rises unattended.
"If moves are irregular, there is a possibility we might take whatever action deemed necessary for the sake of the country," Fujii told a news conference after a cabinet meeting.
He said that his message had been consistent but that it was being misinterpreted by markets.
"I never said a word about leaving a strong yen as it is. I'm saying it's wrong, as history shows, for countries to continuously take policies aimed at lowering the value of their currencies," Fujii said.
Toyoo Gyohten, an adviser to Fujii on currency matters, agreed with the finance minister's comments that intervention is a possibility. Gyohten also said that the yen's recent rise wasn't sharp and that it is stabilising now.
Gyohten was director general of the MOF's international bureau at the time of the Plaza Accord in 1985, when rich countries agreed to let the dollar depreciate to reduce the United States' trade deficit. He then served as Japan's top currency official until he retired from the MOF in 1989.
This month, the yen has neared January's 13-year high of 87.10 per dollar as the U.S. currency has fallen to its lowest in a year against the likes of the euro and Australian dollar.
While the dollar has been pressured in part by ultra-low interest rates and lost about 3 percent on the yen in September, the Japanese currency has only gained about 1 percent on the euro and none at all against the Australian dollar as investors have resumed buying of higher-yielding assets, including currencies.
Persistent strength in its currency has prompted the Bank of Canada to warn about the possible effects a strong Canadian dollar could have on returning inflation to its target range.
DOUBTS ON CREDIBILITY?
Analysts said market forces had led Fujii to beat a retreat from his previous comments.
"Fujii appears to have been jolted by the yen's rapid appreciation and is worried that the strong yen would throw cold water on the economic recovery led by exports," said Takumi Tsunoda, an economist at Shinkin Central Bank Research Institute.
"But it is unlikely the government actually will intervene in the market."
The yen has strengthened steadily from about 93.00 to the dollar at the start of September as Fujii said he did not see a need to weaken the Japanese unit for the sake of the country's exporters and that a strong currency also had benefits.
It hit 88.22 to the dollar on Monday according to Reuters data, the highest since January, before easing towards 90.00.
The dollar climbed back above 90.00 yen briefly on Tuesday, reflecting Fujii's repeated warnings that currency moves were getting too one-sided towards yen rises.
"Until yesterday, he seemed to cheer the strong yen, but now he can't stand it," said Dariusz Kowalczyk, chief investment strategist at SJS Markets Ltd in Hong Kong.
"It puts a question mark on the stability of his policies and how well they are thought out for the long term. It might be better to support exports in the short term and allow the currency to strengthen later once domestic demand picks up more."
In the past, Japan intervened to weaken the yen to help its exporters stay competitive.
But Tokyo has not intervened in the currency market since March 2004, after a 15-month-long, 35 trillion yen ($390.4 billion) selling spree aimed at preventing the yen's strength from snuffing out an economic recovery. (Additional reporting by Hideyuki Sano, Tetsushi Kajimoto; Editing by Hugh Lawson & Kim Coghill)