The report, issued by the Economic Planning Agency (EPA), maintained its overall assessment that the economy was in a "prolonged slump", but changed the wording from the previous report to describe conditions as "extremely severe" instead of "exceedingly severe".

"We revised our assessment slightly downwards by changing the expression to show an increase in severity," Takashi Omori, national economic division director of EPA's research bureau, told reporters.

He added that Japan must heed the possibility that uncertainty over economic prospects among market participants could affect consumer and corporate sentiment.

The market's uneasiness stemmed not only from Japan, which was suffering from worries over the health of its financial sector, but also from economic and political turmoil in Russia and a fall in US stock prices, he said.

Tokyo share prices dipped below 14,000 last Tuesday to a level not seen since March 1986. Long-term market interest rates fell below one per cent to a record low of 0.995 per cent on the same day. But the economy was unlikely to suffer a further sharp downturn as already announced economic stimulus measures centering on public works spending were expected to have an impact in the coming months, Omori said. A continued decline in inventories and a halt in a fall in exports were brighter factors for the economy, while a drop in housing investment due to a decrease in construction of apartments was a dampener, the report said.

Consumption remained sluggish and corporate capital investment continued to decline, especially among smaller firms. Employment conditions were also severe.

"Although the assessment of consumption and capital investment remains basically unchanged from the previous month, the fact that they are still sluggish means that it could well worsen in the coming months," Omori said.

Exports were steady, with strong growth in shipments to Europe and the United States offsetting falls to Asia. Imports were still on a declining trend, the report said.

Omori said the yen's strengthening against the dollar would not immediately affect trade.

Tokyo share prices opened fractionally lower on Tuesday after a surge of over five per cent on Monday, which analysts said was due mainly to buying by government-related pension funds.

Analysts said that with corporate profits falling, the stock market is likely to come under further pressure later in the year.