UPDATE 2-BOJ may forecast 3 years of deflation - sources

* Persistent deflation may delay exit from low interest rates

* Output gap unlikely to narrow much - sources (Adds details)

TOKYO, Aug 6 - The Bank of Japan will probably forecast three years of deflation extending to March 2012 as weak domestic demand is seen capping economic growth, sources with direct knowledge of the matter said, which could delay its exit from its current low interest rates.

The central bank already expects Japan's core consumer price index (CPI) to fall 1.3 percent in fiscal 2009 and drop 1.0 percent in fiscal 2010 which ends in March 2011. It will issue its price forecast for the year to March 2012 on Oct. 30.

With economic growth expected to remain anemic due to weak final demand, there is a high possibility that consumer prices will remain negative in fiscal 2011 too, at least three sources said on condition of anonymity.

"Given that Japan's output gap likely won't narrow much in coming years, a rough calculation would show consumer prices will continue to fall in fiscal 2011," one source said. The other sources confirmed this view.

They declined to be named because of the sensitivity of the matter. All have direct influence over policy.

The output gap measures how much actual gross domestic product (GDP) deviated from potential GDP, or the volume of activity when the economy is running at full capacity.

The BOJ will announce its forecasts for core CPI and GDP for fiscal 2011 when it issues its semiannual report on Oct. 30.

OUTPUT GAP TO WEIGH

The BOJ has lowered interest rates to near zero and has taken unconventional steps to lessen the impact of the global financial crisis, such as increasing its government bond purchases as well as buying commercial paper and corporate bonds from banks.

Many BOJ officials believe no further policy action is needed unless Japan risks slipping into a deflationary spiral, in which falling prices and a weak economy feed into each other.

Even if deflation persists, the BOJ is unlikely to revert to full-blown quantitative easing, which in Japan involved flooding the banking system with cash to meet a specific monetary target, or step up credit easing as long as the price falls are mild.

But persistent deflation would make it difficult for the BOJ to justify exiting its ultra-loose monetary policy.

"Interest rates are already near zero, and the BOJ thinks it is already aggressively easing monetary policy, so it won't do anything further," said Masamichi Adachi, senior economist at JPMorgan Securities Japan.

"But it will maintain its cautious stance on the economy."

Having just emerged from almost a decade of deflation after the collapse of a property bubble in the 1990s, Japan's economy has been sideswiped by the global financial crisis that started in 2007 with a U.S. mortgage market meltdown.

While the economy is expected to have bounced back in April-June after four straight quarters of contraction, analysts say any recovery will be fragile as companies slash jobs and cut capital spending, weakening domestic demand.

Core consumer prices fell a record 1.7 percent in the year to June with weakening household demand for goods playing an increasing part.

Price falls could accelerate further should the output gap widen more from the record minus 8.5 percent logged in the January-March quarter, the government said in a report issued last month.