The Bank of Japan on Thursday revised its growth outlook upwards for the next two years and maintained its ultra-loose monetary policy as it warned that the pandemic makes clear forecasts less likely.
However, for the current fiscal year to March the central bank expects the economy to shrink 5.6 percent, against its October estimate of a 5.5 percent contraction.
The announcement comes with parts of the country including Tokyo and Osaka under a state of emergency that requests shops and restaurants close early.
While Japan's Covid-19 outbreak remains comparatively small, with around 4,700 deaths overall, there has been a sharp spike in cases this winter.
But the bank saw brighter times on the horizon in its quarterly report, published after a two-day policy meeting.
For the 12 months to March 2022 it expects growth of 3.9 percent, and 1.8 percent the following year. That compares with previous estimates of 3.6 percent and 1.6 percent, respectively.
The bank's governor Haruhiko Kuroda said the impact of the pandemic should gradually ease as vaccines reach industrialised economies followed by developing nations.
"Our domestic economy continues to face a difficult situation because of the coronavirus pandemic. But we have seen that the underlying trend is picking up," Kuroda told reporters.
"Corporate earnings and business sentiment are gradually improving after having dramatically deteriorated."
Individual consumption is also recovering although in-person services such as restaurants and hotels continued to face pressure, he said.
"While monitoring the pandemic, we will not hesitate to take necessary monetary easing actions," Kuroda added.
He said that while two major sources of global uncertainty -- Brexit and the US presidential election -- had gone relatively smoothly, the virus was still unpredictable.
The bank warned in its report that its latest forecasts "could change depending on the consequences of Covid-19 and the magnitude of their impact on domestic and overseas economies".
It expected prices to fall 0.5 percent in the current year to March, but said they will likely rise 0.5 percent and then 0.7 percent over the next two.
The negative interest rate of 0.1 percent on bank deposits was left unchanged, as well as a policy of unlimited purchases of government bonds.
BoJ policymakers are currently reviewing its ultra-loose tactics, in light of criticism that they are hurting commercial banks' financial health while distorting the market.
"If there are more effective and sustainable monetary easing steps, we would accept those," Kuroda said.