The Bank of Japan cut its assessment of the economy for a second month in a row in a sign that a global slump sparked by the US credit crisis may be spreading too quickly for Japan to avert recession.
"Economic growth has been sluggish against the backdrop of high energy and material prices and weaker growth in exports," the central bank said in a statement, as it decided unanimously today to keep interest rates on hold at 0.5 per cent.
The central bank's assessment was even more cautious than one it made in July when it cut its assessment to say economic growth was slowing further due to high energy and raw material costs.
Data released since then showed the world's second-largest economy shrank in the second quarter as crumbling US and European export markets hit factories, and consumers tightened belts to cope with high food and fuel costs.
That contraction was the biggest in seven years and probably ended Japan's longest expansion since World War Two.
Exports to Asian emerging markets weakened in June from a year earlier after sustaining growth in the face of a slump in US and European demand.
Industrial output has fallen for two straight quarters - a harbinger of Japanese recessions for 50 years.
Markets are focusing on what governor Masaaki Shirakawa will say about the economy when he holds an embargoed news conference later today. His comments will likely be released some time after 4.15 pm (0715 GMT).
The scale of the worldwide slump triggered by a meltdown in US mortgages last year is driving trading in global foreign exchange markets. The dollar has rallied to its highest in seven months against an index of major currencies on bets that Europe and Asia will suffer more than investors had previously expected.
The BOJ said in the statement it would conduct monetary policy flexibly while examining risks in both directions - a phrase the bank has been using since April to show it has no bias towards either raising or lowering rates.
While a shrinking economy is its main focus, the BOJ is on guard against rising prices. Annual core consumer inflation hit a decade-high 1.9 per cent in June due to the surging cost of food and fuel.
But the BOJ's task is less complicated than that of the European Central Bank or the US Federal Reserve as rises in energy and food prices have not fed through into wages and other costs.
Money market futures suggested some investors saw a chance of a BOJ rate cut by March next year but analysts said this had to be taken with a grain of salt as price moves were exaggerated in a relatively thin market.
Details of the BOJ's economic assessment will be realised by the central bank in a monthly economic report tomorrow.
The government has acknowledged that Japan is either heading into a recession or is already there, ending a growth cycle that began in early 2002.
Japanese officials measure the start of a recession from the point at which growth begins to slow. A more widely used definition is two quarters of contraction in GDP.
Reuters