By Satoshi Sugiyama and Tetsushi Kajimoto

TOKYO (Reuters) - Japan's economy contracted in the first quarter, squeezed by weaker private consumption and external demand and throwing a fresh challenge to policymakers as the central bank looks to lift interest rates away from near-zero levels.

Preliminary gross domestic product (GDP) data from the Cabinet Office on Thursday showed Japan's economy shrank 2.0% annualised in January-March from the prior quarter, versus a 1.5% drop seen in a Reuters poll of economists. It followed a slightly positive reading in the fourth quarter.

The reading translates into a quarterly contraction of 0.5%, versus a 0.4% decline expected by economists in the Reuters' poll.

Private consumption, which accounts for more than half of the Japanese economy, fell 0.7%, versus a 0.2% decline seen in the Reuters poll. It was the fourth straight quarter of decline, the longest streak since 2009.

Capital spending, a key driver of private demand-led growth, fell 0.8% in the first quarter, versus a decline of 0.7% seen by economists in Reuters' poll, despite hefty corporate earnings.

External demand, or exports minus imports, knocked 0.3 of a percentage point off first quarter GDP estimates.

Policymakers are counting on rising wages and income tax cuts from June to help spur flagging consumption.

The drag to growth from an earthquake in the Noto area this year and the suspension of operations at Toyota (NYSE:TM)'s Daihatsu unit are also expected to fade.

A sharp decline in the yen to levels unseen since 1990 has fueled concerns about higher living costs, squeezing consumption.