The Bank of Japan says prices could fall for three years
Japan's central bank has kept its key interest rate unchanged at just above zero and underlined its determination to overcome deflation.
As widely expected, the board of the Bank of Japan unanimously opted to keep interest rates at 0.1%.
It said the world's second largest economy was improving, but further government support was needed to maintain the recovery.
The board also said overcoming deflation was a "critical challenge".
"Japan's economy is picking up mainly due to various policy measures taken at home and abroad, although there is not yet sufficient momentum to support a self-sustaining recovery in domestic private demand," it said.
The board added it expected Japan's economy to shrink by 2.5% in the current financial year, an improvement on its previous estimate of a 3.2% contraction.
It also forecast growth of 1.3% for the 2010-2011 financial year, up from its previous estimate of 1.2%.
The bank was less optimistic about deflation, saying that prices were likely to continue falling for three years.
"The bank recognises that it is a critical challenge for Japan's economy to overcome deflation and return to a sustainable growth path with price stability," it said.
Some analysts expressed disappointment at the government's attempts to stop prices falling.
"I think deflation will be deeper than they think. I find it very disappointing that the central bank has decided not to change its policy," said Darius Kowalczyk, chief investment strategist at SJS Markets in Hong Kong.
"They should expand their quantitative easing policies and be more aggressive, like Western banks were during the crisis."
Standard & Poor's credit rating agency also expressed concern about both deflation and the high levels of Japanese government debt.
It affirmed the economy's AA rating, but revised its outlook down from "stable" to "negative".
"The outlook change reflects our view that the Japanese government's diminishing economic policy flexibility may lead to a downgrade unless measures can be taken to stem fiscal and deflationary pressures," it said.