In the context of the global economic crisis, the Japanese economy has fallen into its deepest recession of the post-war era. Output is projected to contract by around 6% in 2009, reflecting a plunge in exports and tighter financial conditions. Prompt action by the authorities to stabilise financial markets, cut the policy interest rate and implement large-scale fiscal stimulus is cushioning the blow and sets the stage for a mild recovery, against the backdrop of a projected sluggish rebound in world trade. With deflation entrenched, the Bank of Japan should keep the policy interest rate close to zero. As the stimulus packages fade and fiscal consolidation begins, sustaining the expansion will depend increasingly on private domestic demand, which requires economic reforms to create new drivers of growth. Reforms in the labour market, where rising dualism has constrained wages and private consumption, and the non-manufacturing sector, where productivity gains lag far behind manufacturing, are especially important. Policy reforms in a number of other areas are needed for robust and sustainable growth.