TOKYO Japan's government downgraded its main economic assessment for the second month in a row on Friday, acknowledging for the first time the world's second-biggest economy had slipped into a deflationary state, AFP reported.

The gloomy report came before the Bank of Japan holds a crucial board meeting on Monday, which analysts and reports said would decide to return to the zero interest rate policy controversially abandoned last year.

"Economic recovery appears to be pausing," the cabinet office said in a monthly report submitted to Prime Minister Yoshiro Mori.

The term "pausing" was last used in January 1998, before the economy eventually sank into recession. It also marked a rare, second straight monthly downgrade.

"Reflecting the slowdown of the U.S. economy, Japanese exports have faltered, resulting in a weakening of industrial output," the cabinet office said.

The more bearish assessment compared with the analysis in February that "the pace of economic recovery has become more moderate."

The assessment also declared the economy was now in a deflationary trend in the first attempt to clarify the government's opaque definition of deflation -- a "state in which prices are falling while the economy is receding."

The International Monetary Fund recognizes deflation as two years of falling prices regardless of whether gross domestic product is growing, which would apply to Japan.

"If we are to term prolonged price falls as deflation, Japan's economy is now experiencing mild deflation," Taro Aso, state minister for economic and fiscal affairs, said during a morning cabinet meeting.

The deflation is discouraging consumers from spending and hurting corporate earnings. Core consumer prices dropped 0.5 percent in January in their 16th straight fall, following a 0.6-percent fall the previous month.

"It is a very rare development internationally and historically that the CPI (consumer price index) falls for two years in a row," cabinet office economist Haruhito Arai said, describing the trend as "virulent."

Finance Minister Kiichi Miyazawa said Central Bank Governor Masaru Hayami had already decided on further action, after two rounds of interest rate cuts last month.

"Hayami said the BOJ is in a position to mull the next move," Miyazawa said after the morning cabinet meeting, which was attended by Hayami.

"The BOJ governor said the BOJ is providing ample liquidity and has implemented policy changes twice, and is now considering more," the finance minister told reporters.