Japan's factory output fell by the most in more than two years in June although the labor market improved, a sign Prime Minister Shinzo Abe's pro-growth policies are bearing fruit but still have far to go to establish a durable recovery.

The first fall in industrial production in five months largely reflected manufacturers trying to avoid inventory build-up, and they forecast a brisk pick-up in July.

The best levels of unemployment and job availability since 2008 augur well for the private spending that Abe has sought to trigger through aggressive monetary and fiscal stimulus since he took office in December.

The batch of data serves as the six-month scorecard for Abe, who is seeking to strike a balance between reviving growth and fiscal consolidation, while facing a tough decision on whether to go ahead with a planned sales tax hikes from next year.

The 3.3 percent month-on-month fall in industrial output was the largest since March 2011, when a massive earthquake and tsunami ripped through Japan's northeast coastal areas, Ministry of Economy, Trade and Industry data showed on Tuesday.

It missed forecasts of a 1.8 percent fall in a Reuters poll due to lower production of cars amid decline in demand at home and abroad. Output of semiconductors also decreased, reflecting weakening demand for smartphones in Asia.

Output had risen 1.9 percent in May, and the ministry stuck to its assessment the trend was showing a moderate pick-up. Manufacturers expect output to rise 6.5 percent in July and fall 0.9 percent in August.

"I think there is no change in the trend that production is expected to stay on a steady recovery as June trade data was good, benefits from the yen's weakness are appearing and domestic demand is solid," said Yoshiki Shinke, chief economist at Dai-Ichi Life Research Institute.

SALES TAX HIKES

Data on the labor market showed the jobs-to-applicants ratio rose to 0.92 in June from 0.90 in May, meaning jobs were available for more than 9 out of 10 job seekers. This marks the strongest demand for workers in five years.

The unemployment rate fell to 3.9 percent in June, its lowest since October 2008.

However, wage earners' household spending unexpectedly fell 0.4 percent in June from a year earlier, compared with a median estimate for a 1.0 percent increase, suggesting rapid gains in private consumption may be moderating slightly.

"We see positive numbers emerging including a drop in the jobless rate, which is one example," Finance Minister Taro Aso told reporters, saying a decision on whether to raise the sales tax as planned next April would be taken in the autumn.

"Certainly the mood is looking up," he said.

There are signs Abe is rethinking the sales tax hike out of concern it could derail a nascent economic recovery. Abe has ordered a study of alternatives for implementing the tax hikes, including introducing them more gradually, government sources have said.

Aso said the final decision would be made after a summit of the world's 20 major economies in early September, when Japan is expected to show a credible fiscal plan to fix public debt, with revised April-June GDP data due on September 9 also a factor.

Japan's economy grew at an annualized 4.1 percent rate in the first quarter, led by firm private consumption and a pickup in exports, posting the fastest growth among major economies.

But China's slowdown, Europe's stagnation and the potential impact on emerging economies from the U.S. Federal Reserve's eventual tapering of monetary stimulus cloud the outlook for the export-reliant economy.