WRAPUP 2-Bleak Japan factory output points to long recession

TOKYO, (Reuters) - Japanese industrial production dropped sharply in October and manufacturers warned of record falls in coming months, prompting warnings that growing global gloom means Japan's recession will be even deeper and longer. The bleak news on Japanese factory output may point to a longer and deeper global recession, with the euro zone and U.S. economies also contracting and growth slowing in China. With household spending also sliding, Japan is now firmly caught up in the financial crisis, with its big exporters such as Toyota and other car makers facing tumbling orders from key customers in Western markets -- and increasingly across Asia. Falling oil prices point to the risk of a return to deflation, although economists are divided on this and whether the Bank of Japan will return to a zero-interes-rate policy. Finance Minister Shoichi Nakagawa called for more action by the BOJ to deal with the worsening economy. Exporters have been the main engine of growth for Japan's economy but manufacturers forecast their biggest ever quarterly fall in output in the fourth quarter. "Production is falling much faster than we expected. Companies are adjusting their production very quickly," said Takumi Tsunoda, a senior economist at Shinkin Central Bank Research. "Auto makers are the worst hit, but their turmoil is starting to spill over into other sectors, such as steel makers." Industrial output fell 3.1 percent in October, more than a median market forecast for a 2.5 percent drop, and the outlook is for a record 8.6 percent fourth-quarter contraction. For a graphic tracking monthly industrial output, Industrial output has already been falling for three quarters this year and, with household spending also in decline, economists warn of a longer and deeper recession. "The figures reconfirm that conditions are worsening very badly," said Yoshikiyo Shimamine, chief economist at Dai-Ichi Life Research Institute, warning that U.S. data and problems elsewhere meant there would be no quick turnaround. "It is now the Christmas shopping season in America, and sales of popular items like toys, clothing, high-tech gadgets and digital appliances will likely be really slow. "Chinese firms may be hit by slow sales of toys and clothing, but sluggish sales of high-tech items will impact companies in Japan and Taiwan." Some economists say Japan's recession could run for two more quarters until early next year -- a full year of contraction that would be the country's longest on record. Not helping matters is a rise in the yen to 13-year highs against the dollar last month. It is still around 95 yen per dollar, further curbing profits exporters earn in other currencies. Share prices briefly dipped after the data and Japanese bond prices edged up, but ironically the yen held firm on fears of a longer and deeper global recession, with the low-yielding currency seen by investors as a refuge from the economic storm. DEFLATION RISK Japanese core annual inflation slowed in October for a second straight month, underscoring a view that falling energy costs may heighten the risk of a return to deflation later next year. Excluding volatile prices of fresh fruit, vegetables and seafood but including oil products that are diving in price, core consumer prices rose 1.9 percent in October from a year earlier, slipping from a 2.3 percent increase in September. For a graphic on Japanese inflation, click: Annual inflation excluding oil products dipped to 1.2 percent while partial figures for November, covering Tokyo, pointed to further falls in inflation. "The pace of rises in consumer prices will keep slowing towards the July-September quarter next year and we expect core consumer prices to start falling after July-September next year," said Kyohei Morita, chief economist at Barclays Capital. Japan's jobless rate unexpectedly dropped to 3.7 percent but even that was not good news -- with officials saying it was due to discouraged workers leaving the work force, with vacancies showing the outlook for jobs at a four-year low. The OECD has singled out Japan as facing the biggest threat of deflation among industrialised nations next year, warning on Tuesday that the global financial crisis could further damage the economy. BOJ OUTLOOK SPLIT Analysts are split over whether the threat of deflation will prompt the Bank of Japan to cut rates again in the future after it trimmed them to 0.3 percent last month. Masamichi Adachi, a senior economist at JPMorgan Securities Japan, is among those expecting a return to zero interest rates, warning inflation will slide much faster than some realise. "Japan is getting closer to deflation and the nation's economy will further deteriorate without doubt," Adachi said. But other analysts say it is too early to be talking about persistent deflation, and see limited scope for a BOJ rate cut. Derivative markets are not pricing in a serious chance of a rate cut in the coming months after Friday's data. Bank of Japan Governor Masaaki Shirakawa said this month he was awake to the risk but the central bank does not forecast a return to deflation, which afflicted the nation for about a decade from the 1990s. Japan slipped into recession in the third quarter for the first time in seven years as exports crumbled, joining the euro zone in meeting the commonly used definition of two straight quarters of contraction. The United States is widely expected to follow in the fourth quarter and growth is also slowing in China, another key market for Japan.