Japan released yet more worrying figures on Friday, showing the world's third largest economy was already stuttering before a damaging territorial dispute erupted with its largest trading partner.

Factory output in August shrank by a bigger-than-expected 1.3 per cent from the previous month, the industry ministry said as it admitted production activity was weakening.

The decline was much sharper than an average market forecast of a 0.4 per cent drop.

"Industrial production appears to be weakened," the ministry said in a statement, downgrading its overall assessment. It had said a month ago that production appeared to be flat.

Japan's export-driven economy is struggling to right itself following the March 2011 earthquake and tsunami disaster, while also suffering from Europe's debt crisis, slowing Chinese demand and the strong yen.

Japanese businesses are now worried about taking a hit from the effects of a flare-up in the row between Tokyo and Beijing over the ownership of islands in the East China Sea.

Japan's nationalisation in September of three islands in the chain, called Senkaku in Japan and Diaoyu in China, triggered anti-Japan rallies across China. Major Japanese companies were forced to close factories.

Auto giants Toyota and Nissan said on Wednesday they would cut production in China because demand for Japanese cars has dropped, while airlines have seen large cancellations of seats on China-bound flights.

Mooted Chinese consumer boycotts of Japanese products are also unsettling firms sending goods to China, Japan's number one export market.

The industry ministry, citing a survey of production forecasts by manufacturing companies, said factory output is expected to fall by a further 2.9 per cent in September and to be flat in October.

Mizuho Securities Research and Consulting senior economist Norio Miyagawa said the ministry's outlook survey suggested "output may lose steam even further."

"We are likely to see sluggish output at least until October, especially in the automobile sector," he told Dow Jones Newswires, noting the row with China was a downside risk for the economy.

"If the current disputes with China become prolonged, that will damage Japan's output and the economy."

Kengo Suzuki, forex strategist at Mizuho Securities, said "a fall in foreign demand could further pressure the Japanese economy".

It could also raise expectations for further monetary easing in the long run, he added.

The Bank of Japan last week announced it would spend an extra US$128 billion buying bonds to take its total monetary easing effort past US$1 trillion as it seeks to revitalise the economy.

The move followed similar bond-purchasing plans by the bank's US and European counterparts earlier in the month.

Economists attributed the August production fall to weakening domestic consumer spending and stocked-up inventories as well as China's corporate performance and the debt crisis in Europe.

Data released by the internal affairs ministry on Friday showed no sign of Japan breaking out of years of deflation.

Core consumer prices, which excludes volatile prices of fresh food, fell for the fourth straight month in August, dropping 0.3 per cent year-on-year, data showed.

Yoshiro Sato from Credit Agricole said it was too soon to see any inflationary effect from the September 19 easing announced by the Bank of Japan.

However, "we argue that the BoJ would be required to take further action if the inflation rate does not pick up at a reasonable pace to the +1 per cent price stability goal", he said in a client note.

The government said in a separate survey on Friday that household spending rose a modest 1.8 per cent in August from a year earlier, while the jobless rate fell slightly to 4.2 per cent in August, from 4.3 per cent in July.

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