The Bank of Japan forecast on Tuesday prices would fall less than earlier thought but remained open to further policy easing in the face of renewed government calls for more support for a fragile economic recovery.
Finance Minister Naoto Kan, speaking just hours before the central bank announced it kept its policy rate at 0.1 percent as expected, said that the government wanted to overcome deflation by working with the BOJ.
He is also expected to urge the central bank to show flexibility in its policy in a speech to parliament on Friday, according to the Nikkei newspaper.
As widely expected, the central bank refrained from announcing any new policy initiatives after it launched a new low-cost funding scheme for banks at an emergency meeting in December.
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In a review of its forecasts made in October, the central bank predicted milder deflation in the next fiscal year beginning in April and the following year, mainly reflecting rises in crude oil prices. But it maintained its view that prices would keep falling for three years and repeated its pledge to keep monetary conditions very easy.
Some analysts, however, said the central bank was too optimistic.
"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 Dariusz 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."
The BOJ slightly upgraded its economic growth forecast for next fiscal year but maintained its view that the recovery would remain slow until around autumn this year.
The government is worried that the economy may slip back into recession in the run-up to upper house elections and analysts say the central bank may ease its policy further, for example by buying more government debt or expanding the new funding operation, if economic and market conditions deteriorate.
Once concern is that the strength of the yen, which hit a 14-year high against the dollar in November, could thwart the recovery by hurting Japanese exporters.
"The BOJ appears to be expecting a fast pace of improvement in deflation. But the central bank will remain ready to ease policy should the yen rise more and bring down Japanese share prices," said Junko Nishioka, chief Japan economist at RBS Securities.
The government accused the central bank of being too optimistic when the bank upgraded its assessment in November. That eventually led the BOJ to cave in to pressure and adopt last month a new fund supply operation at which it offers 10 trillion yen ($111 billion) in three-months loans to banks at 0.1 percent. It later declared that it would not tolerate deflation.
Yen borrowing costs have since fallen and pulled the currency off its highs.
The BOJ has been virtually alone among major central banks in further relaxing its policy. The Federal Reserve and the European Central Bank have said they will start phasing out their emergency lending and liquidity facilities in light of improvements in credit markets.
