Japanese gross domestic product (GDP), or total economic output, will grow 2.8 percent in 2006, sharply up from a September forecast of 2.0 percent, the International Monetary Fund said.

Growth in 2005 is now estimated at 2.7 percent.

Asia’s largest economy will shift down a gear in 2007, however, when growth of 2.1 percent is seen, although that is better than an earlier projection of 1.6 percent, the IMF said in its twice-yearly World Economic Outlook report.

"Despite an inevitable slowdown from the 5.0 percent GDP growth rate in the first half of 2005, Japan’s expansion remains solidly on track," it said.

"Most encouragingly, with underlying deflationary pressures easing, there is an increasing prospect of an end to eight consecutive years of declining prices."

Japan’s core consumer prices rose for a fourth straight month in February in the clearest sign yet the economy is finally beating its deflation scourge.

However, with consumer prices expected to turn only slightly positive in 2006, "it is still too early to conclude that deflation is conclusively defeated," the IMF added.

The report puts Japan ahead of the eurozone which is forecast to grow 2.0 percent this year but behind the United States on 3.4 percent.

In Japan, export growth has been supported by strong demand in the United States and China, and a depreciation of the yen.

The expansion is also increasingly being driven by strong domestic demand from firms and consumers, underpinned by rising employment, robust corporate profits and a turnaround in bank credit growth, it added.

This was reflected in the 40 percent rise by the Nikkei-225 index of bluechip shares seen since mid2005, by far the most rapid rise of any stockmarket in the major industrial countries, the IMF said.

It even said there was a chance growth might overshoot its forecasts, particularly if private consumption gains momentum in response to rising employment and labor income.

Japan’s unemployment rate fell to a seven-year low of 4.1 percent in February.

At the same time, however, the economy is entering a delicate phase after the ending of the central bank’s deflation-busting monetary policy and with interest rates expected to rise later this year, the IMF said.

"Given the uncertainties noted above, and the large costs of a deflationary relapse, the monetary policy stance is appropriately expected to be kept highly accommodative for the time being," the report said.

Japan also needs to reduce its public deficit in the face of an ageing population.

Over the past two years, the general government deficit has been reduced from 8.1 percent of GDP to 5.8 percent in 2005 but "further substantial adjustment will be needed in the future," it warned.

Japan’s debt is equivalent to over 150 percent of its annual GDP, the highest among industrialized nations, after its government spent trillions of yen trying to kick-start the economy after the asset bubble burst in the early 1990s.