UPDATE 3-Japan on brink of deflation as CPI stalls

* Japan consumer prices show economy edging towards deflation

* Japan retail sales ckage, following up its budget for the fiscal year starting on April 1 that passed parliament on Friday.

"Japan is facing consumer price deflation," said Akira Maekawa, a senior economist at UBS Securities.

"We expect CPI to turn negative on-year in March and remain negative for at least the rest of this year due to a combination of weaker energy prices and a deterioration in the output gap. Japanese companies are still producing more than consumers want to buy."

Finance Minister Kaoru Yosano told reporters it was still too early to say Japan is in deflation.

But analysts said price falls in durables such as cars and flat-panel TVs were notable, partly as demand crumbles.

Many economists expect Japan to face a second bout of deflation, due to the global financial crisis, and the Bank of Japan forecasts two years of falling prices.

BOJ Governor Masaaki Shirakawa said the central bank will closely monitor the price trend.

"Core CPI will turn negative from now on as a reaction to hikes in energy and food prices from last spring and summer," Shirakawa told a parliamentary committee.

"A worsening of the supply-demand balance in the economy will also add downward pressures on consumer prices."

Economists are watching the inflation index, which strips out both energy and food prices, similar to the core index used in many other developed countries. The index edged down 0.1 percent.

"The core-core index will continue to decline as the economy worsens to widen the output gap," Daiwa's Watanabe said.

LARGEST EVER BUDGET

Japanese lawmakers approved on Friday the government's 88.5 trillion yen ($896.2 billion) budget for the fiscal year starting April 1, the country's largest ever.

Thahed tankan survey due on April 1 is expected to show sentiment among big manufacturers tumbled to the lowest since 1975.

Japan's economy, mired in its worst recession since World War Two, is seen shrinking a further 2.5 percent in the first quarter and 0.4 percent in the second quarter.

Highlighting weak consumption, retail sales fell 5.8 percent in February from a year earlier, a bigger drop than the median market forecast for a 4.0 percent decline, the government said. ($1=98.75 Yen)