Japan's government highlighted the danger of deflation for the first time in three years Friday, warning that falling prices and a further worsening of the labour market could drag on the weak recovery.

Meanwhile, the country's central bank, which kept its key interest rate on hold at 0.1 per cent, took a slightly more upbeat view in its monthly assessment of the economy because of an improvement in exports and private consumption.

The mixed outlook comes at a crucial juncture for the world's second-largest economy. It expanded at a stronger-than-expected rate in the third quarter amid rising factory output but the job market remains tough and many companies have reported quarterly losses.

In its monthly economic report, the Japanese cabinet declared that the economy is in official deflation territory, the first time that has been the case since August 2006. The assessment is hardly a surprise as Japan's consumer price index has been declining for months.

But the slight schism between the government and central bank is significant.

Japan's leaders are clearly worried about the trend. Falling prices, which plagued Japan during its "Lost Decade" in the 1990s, may sound like a good thing, but deflation can hamper economic growth by depressing company profits, lead to wage cuts and cause consumers to postpone purchases. It can also increase debt burdens.

Overall, the cabinet report said that while the economy has been "picking up, it is short of autonomous factors and remains in a difficult situation such as a high unemployment rate." The jobless rate has retreated from a record 5.7 per cent in July to 5.3 per cent in September — still high by Japanese standards.

Finance Minister Hirohisa Fujii voiced grave concern over falling prices, saying that addressing deflation is "a very important point" in managing the economy, according to Kyodo News agency.

The Bank of Japan seemed to be less concerned about deflation and economy in general.

Japan's new ruling Democratic Party of Japan leader Yukio Hatoyama smiles before he is elected as Japan's new prime minister in September. (Toru Hanai/Reuters News Agency)

It said the decline in the consumer price index — which fell 2.3 per cent in September — remained stable and was likely to moderate as the impact from oil prices fades.

The central bank, which was widely expected to keep its benchmark rate unchanged, upgraded its economic assessment for the third straight month, saying government policy measures have lifted consumption. It projected the pace of Japan's recovery is likely to remain moderate until around the middle of the fiscal 2010.

The reports came on the heels of figures Monday showing that Japan's economy grew at an annualized pace of 4.8 per cent in the July-September period. Industrial production has also risen for seven straight months and the decline in exports has shown signs of easing.

Japan's stock market fell for an eighth straight day on Friday, with the benchmark Nikkei 225 sinking 0.5 per cent to 9,497.68.