The news comes as the administration presented a record extra budget to parliament calling for 15.4 trillion yen ($159bn) in government spending to finance a new stimulus package.
Last week, the finance ministry said Japan recorded its first annual trade deficit in 28 years in the just-ended fiscal year.
The cabinet had previously predicted the country's gross domestic product (GDP), a measure of the total value of a nation's goods and services, would be flat in the current fiscal year until March 2010.
"We need measures to support the economy for the long term"
Hiroyuki Sonoda, senior LDP official
It also said GDP was likely to have shrunk 3.1 per cent in the fiscal year that ended last month, worse than the previous estimate of 0.8 per cent.
Based on the latest estimates, Tokyo now expects the two-year period to be the worst for the economy in the country's post-war history.
The largest previous GDP contraction was 1.5 per cent in 1998.
Meanwhile, a senior official in Japan's ruling Liberal Democratic party (LDP) said the country would need another stimulus package in the next fiscal year starting in April 2010.
Hiroyuki Sonoda, the LDP's acting policy council chairman, told a meeting in Tokyo: "We need measures to support the economy for the long term."
Japan has relied heavily on foreign sales of its cars and gadgets to drive economic growth, and is reeling from the collapse in global demand sparked last year by the US financial crisis.
Its economy shrank an alarming annual 12.1 per cent in the October-December quarter, marking the steepest contraction since the oil shock of 1974.