By Tetsushi Kajimoto and Stanley White

TOKYO (Reuters) - Japan's industrial output slid 0.7 percent in August after a hefty gain in the previous month, but analysts see factory activity and the broader economy on track for a steady recovery backed by exports and firm domestic demand.

A separate survey showed manufacturing activity expanded in September at the fastest pace since the March 2011 earthquake, underscoring the strength of the world's third-largest economy.

Retail sales also rose 1.1 percent in August from a year earlier, data showed on Monday, in a sign consumer spending is sustaining momentum.

The data is unlikely to change expectations for Prime Minister Shinzo Abe to decide this week on the planned sales tax hike, the biggest effort by Japan in decades to fix its tattered public finances.

"Factory output is a bit weak now but will return to levels before the March 2011 earthquake around October. Companies are starting to produce more and aren't too worried about uncertainties in the overseas economy," said Takeshi Minami, chief economist at Norinchukin Research Institute in Tokyo.

Abe - whose reflationary policies have boosted share prices, weakened the yen and bolstered sentiment in the world's third largest economy - is expected to make the sales tax decision after confirming readings in a key Bank of Japan business sentiment survey due 8:50 a.m. Tuesday (2350 GMT Monday).

The August drop in industrial output was smaller than a 0.4 percent decline projected in a Reuters poll, and followed a 3.4 percent gain in the previous month, data from the Ministry of Economy, Trade and Industry (METI) showed.

Manufacturers surveyed by the ministry expect output to rise 5.2 percent in September and increase 2.5 percent in October, the data showed.

The Markit/JMMA Japan Manufacturing Purchasing Managers Index (PMI) rose to a seasonally adjusted 52.5 in September from 52.2 in the previous month, remaining above the 50 threshold that separates contraction from expansion for the seventh month.

The survey showed that manufacturing activity expanded at the fastest since February 2011, one month before the natural disaster struck the country's northeast coast.

Japan's economy grew an annualized 3.8 percent in the second quarter, driven in large part by strong consumer spending, and the central bank upgraded its assessment of the economy earlier this month to say it was recovering moderately.

The BOJ's quarterly "tankan" corporate survey will likely show the headline index for big manufacturers' sentiment improved three points from the previous quarter to plus 7, according to a Reuters poll of 22 economists.

(Writing by Leika Kihara; Editing by Eric Meijer)