* Dollar/yen hurt by Sankei report saying BOJ policymakers divided ahead of meeting
* No positive catalysts for Nikkei seen from U.S., Japan monetary policy - analyst
By Ayai Tomisawa
TOKYO, Sept 7 (Reuters) - Japanese stocks dropped on Wednesday morning after exporters and other cyclical shares were hit by a rising yen as weak U.S. service sector activity dashed expectations for a near-term interest rate increase from the U.S. Federal Reserve.
The Nikkei fell 0.8 percent to 16,954.46 in midmorning trade, retreating from a three-month high hit earlier this week.
The dollar declined 0.5 percent to 101.50 yen after slipping to a low of 101.245 earlier, its weakest since Aug. 26.
The dollar-selling was triggered after the Institute for Supply Management's index of non-manufacturing activity fell to 51.4, its lowest level since February 2010, virtually shutting the door on the Fed raising rates as early as this month.
Also souring sentiment was a report in the Sankei newspaper saying Bank of Japan policymakers were divided ahead of the central bank's Sept. 20-21 meeting, at which BOJ Governor Haruhiko Kuroda has said the board will conduct a comprehensive assessment of its massive stimulus programme.
"Investors think that the Japanese market won't likely get positive catalysts from monetary policy in the U.S. or Japan," said Norihiro Fujito, a senior investment strategist at Mitsubishi UFJ Morgan Stanley Securities.
However, hopes the BOJ will buy exchange traded funds to counter market weakness in early trade limited the losses, he said.
"The Nikkei would have fallen 200-300 points without hopes for the central bank's ETF buying," he said.
Selling in exporters and other cyclical stocks offset gains in domestic demand stocks such as utilities and construction shares.
Toyota Motor Corp declined 1.3 percent, Panasonic Corp shed 2.3 percent and Hitachi Ltd fell 1.4 percent.
Banks also came under pressure, with Mitsubishi UFJ Financial Group falling 2.7 percent and Mizuho Financial Group shedding 1.8 percent.
Defensive utility stocks were in demand, with Tokyo Electric Power Co rising 1.4 percent and Kansai Electric Power Co adding 2.4 percent. Construction stocks gained ground, with Taisei Corp rising 2.3 percent and Kajima Corp advancing 0.4 percent.
The broader Topix dropped 0.8 percent to 1,342.09 and the JPX-Nikkei Index 400 fell 0.9 percent to 12,055.67. (Editing by Shri Navaratnam)