By Leika Kihara and Tetsushi Kajimoto
TOKYO (Reuters) - Japan is escaping deflation, the government said on Friday as data showing rising prices, falling unemployment, higher incomes and factory activity gathering momentum pointed to an ongoing recovery in the world's third-largest economy.
Prime Minister Shinzo Abe and the Bank of Japan have gambled on massive fiscal and monetary stimulus to spark life into the economy, and the accumulating signs of an upswing are seen strengthening the case for a planned sales tax increase.
Friday's data painted a brightening picture for a country seeking to escape 15 years of debilitating deflation: core consumer prices posted their biggest rise in nearly five years, unemployment fell to its lowest since late 2008, factory output rose and is expected to rise further, and workers' incomes rose.
"Japan is escaping from deflation," Economics Ministers Akira Amari told reporters.
Pessimists have argued that the benefits of "Abenomics," a three-pillar strategy of fiscal and monetary stimulus combined with a long-term growth strategy, may be short-lived and won't prompt companies to spend more on investment and wages.
And while the rise in prices has been driven largely by higher electricity bills and a weaker yen that has pushed up import costs, the job market strength and rising incomes bode well for personal consumption, which has been a key driver of the recovery.
"The output figure confirms a moderate recovery in factory activity, and both core CPI and the core-core CPI excluding energy indicate that the economy is heading for the end of deflation," said Yasuo Yamamoto, senior economist at Mizuho Research Institute in Tokyo.
GRAPHIC: Inflation, CPI vs core
GRAPHIC: Industrial production
ON TRACK, BUT NOT CERTAIN
Core consumer prices, which includes oil products but not fresh food, rose 0.7 percent in the year to July, a second straight month of increase and the largest since a 1.0 percent rise in November 2008, data from the Ministry of Internal Affairs and Communications showed.
The Bank of Japan has a target of lifting inflation to 2 percent in about two years, a goal many analysts see as optimistic given the deflation that has dogged the economy.
"The majority of gains in consumer prices still come from energy, and the upward pressure on energy prices is likely to start to slow in coming months," said Shuji Tonouchi, senior fixed income strategist at Mitsubishi UFG Morgan Stanley Securities in Tokyo.
"Things are basically on track for the BOJ, but I would not get overly optimistic on prices just yet."
The core-core inflation index, which excludes food and energy prices and is similar to the core index used in the United States, was down 0.1 percent in the year to July, a slower pace of decline than June's 0.2 percent fall.
Separate figures showed factory output rebounded 3.2 percent in July and manufacturers expect further gains in the coming two months, consistent with a PMI survey showing manufacturing grew for a sixth straight month in August.
And the jobless rate improved for the second straight month to hit 3.8 percent in July, the lowest since October 2008.
Household spending edged up in the year to July as the feel-good sentiment prompted consumers to eat out more and spend more on travel and leisure. Wage-earners' incomes also rose an annual 1.3 percent in July, increasing for the fifth straight month.
With domestic demand resilient and underpinning industrial activity, it alleviated some concerns that sluggish growth in emerging markets may weigh on the export-reliant economy.
SIGNS OF CHANGE
At its policy review next week, the BOJ is expected to maintain the stimulus it launched in April, with the focus on whether the board revises up its assessment of the economy to say more convincingly that it is recovering.
Japan's economy grew an annualised 2.6 percent in April-June to mark the third straight quarter of expansion as a pick-up in exports added to sustained strength in personal consumption.
But the growth was slower than expectations, offering ammunition to those seeking to change a plan to raise the 5 percent sales tax rate to 8 percent next April and 10 percent in October 2015.
As the economy strengthens, the debate is focused on whether to double the tax in two stages or increase it more gradually, rather than whether or not to increase the tax.
"I think it would be a matter of whether to make tax hikes incremental or not, but putting off the tax hike itself won't be an option," said Mizuho's Yamamoto.
Abe is expected to make a decision on the tax by early October, with the Bank of Japan and ministers in his cabinet keen to push ahead to demonstrate a commitment to fiscal reform.
"If it's a question of whether today's data is positive or negative for implementing the sales tax, then you could say it's positive," Economics Minister Amari said.
(Additional reporting by Stanley White; Editing by John Mair)
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