* July household spending down 0.2 pct yr/yr vs f'cast +0.7

* Jobless rate flat, job availability at 43-year high

* Inflation remains subdued despite strengthening economy (Adds corporate examples, context on policy and economy)

By Leika Kihara

TOKYO, Aug 29 (Reuters) - Japan's household spending unexpectedly fell in July though the labour market continued to strengthen, offering some hope wage gains will soon accelerate and help the world's third-biggest economy overcome a decades-long battle with deflation.

Many analysts expect the economy to extend its recovery at a healthy clip, with job availability at a fresh 43-1/2-year high in July and improving business confidence set to underpin corporate spending.

But firms face a dilemma even as the economy is on course for its second longest postwar expansion - rising labour costs that cut into their bottom line and pressure to attract price-sensitive shoppers with discounts.

"We'll probably see a gap between companies that have the capacity and pricing power to raise prices and those that don't," said Mari Iwashita, chief market economist at SMBC Friend Securities.

"It's not back to days of deflation when you win just by cutting prices. That's good for the economy. But it means companies are faced with a more complex business environment."

Household spending slid 0.2 percent in July from a year earlier after hitting a two-year high in June, government data showed on Tuesday, confounding a median market forecast for a 0.7 percent increase.

The jobless rate was flat at 2.8 percent in July and 1.52 jobs were available per applicant, the highest since 1974, separate data showed, a sign the economy continued to enjoy what many analysts consider as near full employment.

"We are not too worried about the slowdown in household spending in July as strong job growth continues to support household incomes," said Marcel Thieliant, senior Japan economist at Capital Economics.

Still, consumption is likely to shave off economic growth in July-September after making a net contribution in the second quarter, as rainy weather kept shoppers home in August, analysts say.

That leaves the economy's recovery at a testing point with escalating tensions in North Korea and uncertainty over U.S. President Donald Trump's economic policies raising risks for global growth.

RISING LABOUR COSTS

Japan's economy expanded at the fastest pace in more than two years in the second quarter as consumer and company spending picked up.

But price and wage growth remain stubbornly weak with firms still wary of passing on profits to employees, raising doubts over whether the second-quarter's bounce can be sustained.

The uncertain outlook on consumption has not only discouraged many companies from raising prices but has also driven some to cut prices. That highlighted the challenge faced by the BOJ as it tries to spur inflation to its elusive 2 percent goal in its quest to defeat years of falling prices.

Retail giant Aeon said last week it will cut the prices of 114 food and grocery items at 2,800 outlets to attract consumers, and make up the cost by streamlining operations.

Netherlands-headquartered furniture retailer IKEA's Japanese unit also plans to cut prices amid intensifying competition from rivals like discount retailer Nitori.

Just the same, not all are resorting to price cuts.

The tightening job market has pushed up costs for some companies, prompting them to raise prices despite the risk of scaring away shoppers.

Restaurant chain operator Skylark plans to raise prices from October due to rising raw material and labour costs.

Torikizoku Co, another restaurant chain operator popular for its discount grilled chicken, said on Monday it will raise prices of its dishes from October for the first time in more than 28 years.

"Various costs, including raw material and personnel costs, have risen and we expect this trend to continue," the company said. "It's extremely unfortunate but we had to revise prices as we can no longer make up with cost-cutting efforts alone."

Private consumption - which accounts for almost 60 percent of GDP - rose in the second quarter at the fastest pace in more than three years, a sign consumers finally have shaken off the impact of a sales tax hike in 2014.

Some analysts were upbeat on household consumption, saying it has bottomed out. That augurs well for core consumer prices, which rose 0.5 percent in July from a year earlier - still quite a distance from the BOJ's 2 percent target.

"The upshot is that even though the tight labour market has yet to result in a marked pick-up in wage growth, strong job gains continue to support household incomes," Capital Economics' Thieliant said.

(Additional reporting by Sumio Ito and Sam Nussey; Editing by Shri Navaratnam)