Deceleration in the United States and China, on top of Europe's debt crisis, caused the downgrade, the government said on Tuesday, warning that further global slowdown and sharp market swings posed risks to the world's third-largest economy.
The first such downgrade since October 2011 matches the assessment of private-sector analysts, but is somewhat bleaker than the view of the Bank of Japan (BOJ), which has said the economy is starting to pick up moderately.
"Looking at both domestic demand and overseas economies, I don't expect the economy to slide back into a recession but I cannot say it will stage a recovery either," said Yasuo Yamamoto, senior economist at Mizuo Research Institute in Tokyo, adding that Japan may enter a soft patch in the third quarter.
The government assessment underscores policymakers' concern that fresh stimulus measures could be needed, as exports may struggle to recover before the effect on the economy of spending on rebuilding from last year's earthquake begins to fade.
"The economy is moderately recovering helped by reconstruction demand, while some weak movements were seen recently," the Cabinet office said in its monthly report.
In the previous month's report, the government also said the economy was recovering moderately on reconstruction demand but merely noted there were difficulties. The latest report's reference to "weak movements" struck a more negative note.
Japan's economy has outpaced growth of most G7 countries on robust private consumption and reconstruction spending. But July trade data showed the sharpest drop in exports since January, in line with trends seen among other export-driven economies in Asia, casting doubt on the country's recovery prospects.
The BOJ frets that the timing of a recovery may be delayed, but wants to hold off on easing monetary policy again unless risks heighten enough to kill any chance of a recovery.
"The BOJ feels it has eased enough already so it is likely to stand pat for the time being, though it may cut its economic assessment next month following the poor trade data," said Mizuo Research Institute's Yamamoto.
Some analysts expect the next monetary easing to come on Oct. 30, when the BOJ issues fresh long-term economic and growth projections, and may offer a bleaker assessment on the outlook if global growth remains sluggish.
Companies feeling pain
Japan's economy slowed to 0.3 per cent in April-June as Europe's debt woes weighed on global demand, and economists have trimmed forecasts for growth in the second half of 2012 in a Reuters poll this month.
But their forecast for the current business year, ending in March 2013, matched that of the government and the BOJ, which both project a 2.2 per cent expansion.
For now, policymakers are unlikely to sharply trim their projections for this fiscal year with strong growth in the first half seen offsetting the expected weakness later this year.
But they may be forced to slash their projection of 1.7 per cent growth for the next fiscal year if demand for Japanese goods fails to pick up in major markets such as China.
Reflecting the plight of big electronic makers suffering from tough global competition and a strong yen, TV maker Sharp said it would offer severance packages to as many as 2,000 workers in Japan as part of a plan to lay off one-tenth of its global workforce to cut costs.
Earlier this month, the BOJ reiterated its expectations that overseas growth would gradually pick up while warning that there was a high degree of uncertainty over the outlook. In the August report, the government also lowered its outlook for the world economy.
Flagging concern that personal consumption, which accounts for about 60 per cent of the economy, may lose momentum, the government cut its view on private spending, saying it is in a moderately increasing trend, again using a slightly more negative term than one month earlier.
"We used the word 'trend' to show that the pace of increase is slowing. Car sales are leveling off after a rapid increase earlier this year. In addition, poor weather in June has hurt consumption of clothing, beverages and air-conditioners," a Cabinet office official said.
The government cut its view on exports and industrial production, saying shipments overseas were weakening and factory output leveled off recently. In July it said exports were showing signs of recovery and output was recovering moderately.