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TOKYO (Reuters) - Japan's economy shrank an annualized 7.1 percent in April-June from the previous quarter, worse than a preliminary estimate, and adding to doubts over whether the central bank can achieve its target of 2 percent inflation early next year.
The contraction was the biggest since January-March 2009, when the global financial crisis hit Japan's exports and factory output, and some analysts now expect the economy to barely grow in the current fiscal year to March 2015.
The weak performance following a sales tax hike in April will keep the Bank of Japan and Prime Minister Shinzo Abe's government under pressure to expand fiscal and monetary stimulus in order to lead the economy out of a long deflationary phase.
"Growth this year will be less than what policymakers are expecting. The BOJ will ease policy in April because inflation will be too low to meet its target," said Takuji Aida, chief economist at Societe Generale Securities.
GDP was revised down from a preliminary 6.8 percent drop, according to Cabinet Office data released on Monday, and was more than the median market forecast for a 7.0 percent decline in a Reuters poll of economists.
The revision was largely due to a bigger than expected fall in capital expenditure and a deeper decline in consumer spending, suggesting the economy could struggle to overcome the April sales tax increase.
The weakness in capital expenditure casts doubt on the BOJ's expectations that companies, which saw revenues rise thanks to the stimulus policies undertaken so far, will boost investment and hiring.
The central bank has said consumer inflation will head toward its 2 percent target as long as the economy grows above its potential, considered around 0.5 percent. The latest data suggested that was in the balance, with several analysts expecting even more minimal growth.
"Recent data have been weak overall, and the economic recovery has been slower than projected," said Yoshiki Shinke, chief economist at Dai-ichi Life Research Institute, who expects the economy to stay flat this fiscal year.
Takeshi Minami, chief economist at Norinchukin Research Institute, also cut his projection to 0.2 percent growth for the current fiscal year, citing sluggish capital spending.
"Inflationary pressure will weaken reflecting sluggish economic growth," he said. "At some point, the government and the BOJ will have to take some steps (to revive growth)."
In its latest forecast issued in July, the BOJ expects the economy to expand 1.0 percent in the current fiscal year, more than the 0.4 percent increase forecast in a Reuters poll last month. The bank is set to cut that projection at its next review its long-term projections in late October, sources have told Reuters.
Adding to the gloom, Japan's service sector sentiment worsened for the first time in four months in August as bad weather kept consumers at home.
Policymakers had foreseen that the economy would shrink in the April-June quarter as consumers withheld spending after a shopping spree ahead of the sales tax hike to 8 percent from 5 percent on April 1.
But their forecasts of a moderate recovery in the current quarter, have looked increasingly over-optimistic in light of a run of weak data, including a slump in household spending and tepid output growth in July.
Whether the economy has picked up since then will be crucial to Abe's decision, expected by year-end, on whether to proceed with a scheduled second increase in the sales tax to 10 percent in October next year.
Exports were starting to recover and as long as the economy expands in July-September, Abe is likely to go ahead with the second increase, Societe Generale's Aida said.
But he also expected the government to launch a fiscal stimulus package to offset the tax hike's impact on growth.
If the economic recovery falters, it will also heighten pressure on the BOJ to expand the already massive monetary stimulus that it deployed in April last year.
The BOJ, which kept monetary policy steady on Thursday, remains unfazed so far by the soft data, arguing that the pain from the tax hike is temporary, with household spending set to pick up as a tightening job market pushes up wages.
BOJ Governor Haruhiko Kuroda has also expressed confidence the bank can meet its inflation target sometime in fiscal 2015, but many private-sector economists say it will take longer.
($1 dollar = 105.1800 Japanese yen)
Additional reporting by Tetsushi Kajimoto, Stanley White and Izumi Nakagawa; Editing by Eric Meijer and Simon Cameron-Moore