The surprise 11.3 percent fall in core orders raises concern that a recovery in capital spending will be delayed, creating a headache for the Democratic Party-led government, which wants to avoid slipping back into recession before elections in mid-2010.
If that were to happen, Finance Minister Naoto Kan may start leaning on the Bank of Japan again for it to support the fragile recovery.
In a reminder of the kind of pressure he could bring to bear, Kan said on Thursday that the BOJ had various options in guiding monetary policy and the government would continue to work with it to support the economy.
The BOJ has a lot of experience and authority (in monetary policy) and I want to work with it while keeping close communication. And I believe we are working well with each other at the moment, Kan said in an interview with reporters.
Annual wholesale price falls slowed in December as forecast, but economists expect deflation to persist as the weak economy also means firms need to cut prices to lure consumers to spend.
In a sign deflation expectations are deepening, a BOJ survey showed over 18 percent of Japanese expect consumer prices to fall in the coming year.
Core machinery orders totaled 625.3 billion yen ($6.8 billion) in November, hitting their lowest level since the data series began in 1987. The fall in the highly volatile series, seen as an indicator of capital spending, came despite economists' median forecast of a 0.2 percent gain.
The weak reading cushioned declines on Thursday in Japanese government bonds, which were hurt by a bounce in Tokyo stocks and weaker U.S. Treasuries.
Although exports and industrial output have been recovering, companies are not so positive about capital spending because the level of exports and output is still low, said Takumi Tsunoda, a senior economist at Shinkin Central Bank Research.
I think orders have hit bottom but they may not show a clear recovery in the near future.
For a graphic of machinery orders click:
The March 10-year JGB futures dropped 0.14 point to 138.97 after two straight days of gains.
DEBT CONCERNS REMAIN
Weak capital spending may remain a drag for Japan's economy, which has just emerged from its worst postwar recession due mostly to solid demand for its goods in Asia.
Manufacturers' orders fell 18.2 percent, mostly in reaction to a jump the previous month. The weakness was even clearer in orders from non-manufacturers, which fell 10.6 percent on slack demand from the telecoms and financial sectors.
The government cut its assessment of machinery orders to say they are leveling off but showing weak signs in some areas.
Many companies remain wary of boosting capital spending as they are saddled with excess capacity. Capacity utilization is still about 80 percent of levels before the Lehman crisis.
Big manufacturers plan to cut their capital spending by a record 28.2 percent in the fiscal year ending in March, according to the BOJ's December tankan survey.
If capital spending starts declining again, the government and ruling coalition lawmakers may start calling for additional spending to support the economy.
The government crafted a record budget for next year that will inflate the country's huge debt, already nearing 200 percent of GDP.
Concerns about rising debt supply and a possible credit downgrade have hurt longer-term bonds and caused the JGB yield curve to steepen, with the five- to 20-year yield spread hitting its highest level in a decade in December.
Japanese credit default swaps blew out in October and November, and the interest rate swap curve reached its steepest in fours years as investors worried that Japan's growing debt mountain will be increasingly more expensive to fund.
Kan, the new finance minister who is also in charge of economic analysis, is seen as less hawkish on fiscal policy than his predecessor Hirohisa Fujii, who stepped down last week due to health problems.
Slack domestic demand is also weighing on prices.
Wholesale prices, as measured by the corporate goods price index (CGPI), fell 3.9 percent in the year to December, matching a median market forecast.
Although annual wholesale price deflation eased on recent rises in oil prices, weak domestic demand was playing an increasing part in the slide.
Domestic final goods prices, which loosely track the consumer price index, fell 1.1 percent after November's 1.9 percent drop.
Some BOJ officials worry that the economy may start to worsen around April as it loses support from domestic stimulus measures put in place by the previous administration.
At the moment, shares are rising and the yen is weakening so the BOJ won't do anything. But if share prices fall or the yen rises sharply, the BOJ may be forced to take some steps suddenly just as it did last month, said Hiroshi Watanabe, a senior economist at Daiwa Institute of Research.
The bank last month offered cheap funds for a longer period after the yen surged to a 15-year high against the dollar.
It may be prepared to ease monetary policy further this year if need be, with its options likely to include an increase in its outright purchases of government bonds.
(Writing by Leika Kihara, Editing by Hugh Lawson and Michael Watson)