Weak Japanese economic data and a fall in the dollar to an eight-month low against the yen on Wednesday prodded Tokyo closer to fresh action to support an already fragile economic recovery.

Market speculation that the Bank of Japan (BOJ) will have to relax its already loose monetary policy has increased as policymakers have raised the alarm over a fall in the dollar against the yen, which they fear could hurt exports.

The dollar dropped below 85 yen on Wednesday and while the finance minister said he was watching the market extremely carefully, he declined to comment on the possibility of currency intervention.

If the dollar slips below November's low of 84.82 yen, it would mark the currency's weakest level in 15 years.

A rapid yen rise would boost deflationary factors, so the government and the BOJ must act as one in considering what to do given our commitment to act against deflation, Kohei Otsuka, the vice banking minister told Reuters in an interview.

This week the BOJ avoided fresh policy action over the yen's rise, which some policymakers worry will undermine the exports that have pulled Japan out of the global downturn.

A faltering U.S. recovery -- which prompted the Federal Reserve to take a fresh step on Tuesday to support the economy -- and a slowdown in China could further undermine Japan's recovery given its reliance on overseas demand.

Given the weak developments in the U.S. economy, the Japanese economy will probably suffer later this year, so the BOJ wants to save its measures until then, said Seiji Shiraishi, chief economist for Japan at HSBC.

The BOJ slashed its policy rate to just 0.1 percent in the downturn and has set up a bank lending operation to support the recovery.

Ideally, central banks should be forward looking, but the BOJ has almost no measures left. It isn't good for a central bank to be backward looking, but for the BOJ it can't be helped, Shiraishi said.

Indeed, BOJ inaction could backfire, analysts say, because the U.S. Federal Reserve's decision to keep buying government bonds will increase the allure of the yen against the dollar.

Japanese policymakers showed further signs of uncertainty over how to tackle the yen and the economy.

Otsuka, a former BOJ official and now a key policymaker in Prime Minister Naoto Kan's Democratic Party, warned that the yen was at a critical juncture.

But Trade Minister Masayuki Naoshima adopted a more cautious tone, suggesting fresh action was not needed yet. Officials should monitor the economy further before considering extra stimulus, he was reported as saying by Jiji news agency.

RECOVERY WEAKENING?

Data showed that core private-sector machinery orders, a highly volatile series regarded as an indicator of capital spending, rose 1.6 percent in June, much less than a forecast for a 5.5 percent increase.

Manufacturers surveyed in the data from the Cabinet Office forecast that core orders, which exclude those for ships and machinery at electric power firms, will rise just 0.8 percent in the July-September quarter over the previous quarter.

Orders rose in April-June by 0.3 percent.

Other figures showed wholesale prices fell 0.1 percent in the year to July, against a forecast for a 0.1 percent rise and underlining the stubborn deflation plaguing the country. Consumer prices have fallen from a year earlier for 16 straight months.

Many companies just don't expect Japan's economic growth to accelerate rapidly, so it's difficult for the corporate sector to boost spending, said Kiichi Murashima, economist at Citigroup Global Markets in Tokyo.

The BOJ has made it clear that they would need to see a lot more evidence of weaker growth before they would consider a move, he said.

In addition, the ruling Democratic Party is preoccupied with a party leadership election in September, he added.

The Fed's policy committee, the Federal Open Market Committee (FOMC), said on Tuesday it would use cash from maturing mortgage bonds it holds to buy more government debt in a step to support the economy.

The BOJ held off on new policy steps to combat a stronger yen, saving its limited firepower in case the yen rallies more significantly.

The FOMC made an announcement and after that the market moves have become a little one-sided, Finance Minister Yoshihiko Noda told reporters before the dollar fell below 85 yen.

In any case, excessive and disorderly moves in the currency market would negatively affect the stability of the economy and financial markets. Therefore, I am watching market moves with utmost attention.

A Reuters survey showed that data on August 16 is expected to show that Japan's economic growth halved in the second quarter to 0.6 percent from 1.2 percent in the previous quarter, as export growth and private consumption slowed.

(Editing by Neil Fullick)

Japan