By Tetsushi Kajimoto and Kaori Kaneko
TOKYO (Reuters) - Japan's factory output picked up in April and deflation abated slightly as a weaker yen and firmer overseas demand boosted growth, boding well for Prime Minister Shinzo Abe's efforts to shake the world's third-largest economy out of nearly two decades of stagnation.
But core consumer prices continued to fall and manufacturers forecast further weakness ahead, government data showed on Friday, underscoring the challenges the Bank of Japan, under new Governor Haruhiko Kuroda, faces in meeting its 2-percent inflation target.
"The deflationary trend shows no signs of changing," said Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance in Tokyo. He forecast the economy will continue to recover through the latter part of the fiscal year to March 2014.
"However, expectations for deflation, deeply embedded among the public, are very persistent," Kodama said. "It appears quite difficult for monetary easing implemented by Governor Kuroda to achieve a positive cycle of inflation and economic recovery."
Kuroda's BOJ unleashed the world's most intense burst of stimulus in April, promising to inject $1.4 trillion into the economy in less than two years to meet its pledge of achieving 2 percent inflation in roughly two years.
The move has bolstered Japanese share prices to five-year highs. But the massive scale of the BOJ's buying jolted bond markets and pushed up yields, casting doubt on the effectiveness of its policy aimed at slashing borrowing costs.
Core consumer prices, which include oil but exclude volatile costs for fresh food, fell 0.4 percent from a year earlier, matching the median market forecast. The sixth straight fall was a bit narrower than the 0.5 percent decline in March.
Industrial output rose 1.7 percent in April from March for a fifth consecutive increase, the Ministry of Economy, Trade and Industry said, as a pick-up in exports prompts companies to increase production. It marked the longest streak of gains since production rose between March 2009 and April 2010.
The rise beat the market forecast for a 0.6 percent increase and was faster than the 0.9 percent rise in March. Still, in a sign that the gains remain fragile, manufacturers surveyed by the ministry forecast production to be flat in May and fall 1.4 percent in June.
Private data showed that manufacturing expanded in May at the fastest pace in almost a year.
The Markit/JMMA Japan Manufacturing Purchasing Managers Index rose to a seasonally adjusted 51.5, the highest since August, from 51.1 in April, staying above the 50 threshold that separates expansion from contraction for a third month.
STRUCTURAL REFORMS KEY
Japan's economy grew a faster-than-expected 0.9 percent in January-March from the previous quarter, as private consumption and the export rebound led a recovery from a slump last year.
Economists expect the recovery to firm up in the coming quarters backed by exports and private consumption. But risks to the outlook remain, including uncertainty in the global economy, underlined recently by a string of weak data from the United States and China, Japan's two biggest export markets.
"Abenomics," which has caused Tokyo shares to soar in recent months and the yen to fall sharply, appears to be showing early success. But the gains have been cast into doubt in the past few weeks as the bond market has become volatile and Tokyo shares have slumped sharply.
The government is under pressure to build on the improved sentiment by undertaking painful structural reforms, such as deregulation, to foster more sustainable growth.
A key test will be whether Abe proceeds with a plan to double the nation's sales tax in stages to 10 percent. Comments from within Abe's ruling party appeared to cast doubt on his resolve, but Finance Minister Taro Aso stuck to his guns on Friday.
Aso told a regular news conference he doesn't see any chance now of postponing the tax increase and that with the move, "we can ensure the path towards restoring Japan's fiscal health."
The OECD said on Wednesday that any delay by Japan's government in repairing public finances would raise the risk of a spike in Japan's long-term yields, as its central bank pursues massive quantitative easing through purchases of government bonds.
(Additional reporting by Stanley White; Writing by William Mallard; Editing by Shri Navaratnam)