Industrial output dropped 1.2 percent in July compared with a median estimate for a 1.7 percent increase in a Reuters poll and followed a 0.4 percent gain in June.

In a further sign of trouble ahead, the purchasing managers index for August showed manufacturing activity contracted for a third straight month as domestic and external demand suffer.

Manufacturers said they expect output to rise only modestly in August and then fall again in September, which could increase the chance that the economy will contract in the third quarter and pressure policymakers to bolster growth.

"Exports to China and the European Union have been decreasing, so electronics parts makers are cutting back on production to adjust inventories," said Seiji Adachi, senior economist at Deutsche Securities.

"Forecasts for August and September show that output is on a downtrend."

Asia's other major exporters are also feeling the pinch from the global slowdown. South Korea's factory output, which closely tracks exports of smartphones, cars, machinery and ships, fell a larger-than-expected 1.6 percent in July.

The yen showed little response to the surprisingly weak industrial output and PMI data. The downbeat data sent the benchmark 10-year JGB futures contract to a two-week high and it stayed near that level in later trade.

"The Bank of Japan has to downgrade quite considerably their economic outlook going forward, given these figures, and I think this will put them in a very tight spot because they've already promised a 1 percent inflation rate," said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch.

Manufacturers surveyed by Japan's trade ministry expect output to rise 0.1 percent in August and then decrease 3.3 percent in September. JPIP1=ECI

The Markit/JMMA Japan Manufacturing Purchasing Managers Index (PMI) fell to a seasonally adjusted 47.7 in August from 47.9 in July, the lowest level since April 2011, one month after the earthquake struck Japan's northeast coast. JPRPMI=ECI

The core consumer price index, which includes oil products but excludes volatile prices of fresh fruit, vegetables and seafood, fell an annual 0.3 percent in July, separate data showed, matching economists' forecast as deflation persists.

The so-called core-core inflation index, which excludes food and energy prices and is similar to the core index used in the United States, fell 0.6 percent in the year to July, it showed.

Japan's economy has so far outpaced growth of most G7 peers on solid private consumption and reconstruction spending.

But exports in July posted the sharpest annual drop in six months, in line with trends seen in other export-driven Asian economies, casting doubt on Japan's recovery prospects.

The world's third-largest economy cannot expect much of a lift from domestic demand either, with housing starts tumbling 9.6 percent in the year to July, roughly in line with economists' projections and down for a second straight month. JPHST=ECI

The Bank of Japan frets that the timing of a recovery may be delayed, but wants to hold off on easing monetary policy again -- after having acted in February and April -- unless risks heighten enough to kill any chance of a recovery.

Should the economy require more fiscal stimulus, the policy response could be delayed as the government is locked in a dispute with opposition parties over foreign policy.

(Additional reporting by Lisa Twaronite; Writing by Stanley White; Editing by Jacqueline Wong)

• A Permanent Economic Emergency