It said consumer spending was holding firm, with incomes flat and a recovery in consumer confidence.
But it remained cautious over risks from a further slowdown in overseas economies stemming from Europe's debt problems and the impact on financial markets, as well as power supply constraints following the Fukushima radiation crisis triggered by the March earthquake and tsunami.
Fukushima raised public fears over nuclear safety that have prevented the restart of reactors shut for routine checks, and the loss of nuclear power has raised the prospect of forced power rationing and blackouts in the summer peak demand period.
The release of the monthly report comes two days after the Bank of Japan surprised markets by easing monetary policy, boosting its asset purchases and setting 1 percent consumer inflation as a near-term goal.
The government view is in line with that of the BOJ, whose governor Masaaki Shirakawa said after the central bank's meeting that the economy is headed towards a moderate recovery but the outlook remains highly uncertain.
The economy is still picking up slowly, while difficulties continue to prevail due to the earthquake, the Cabinet Office said in the report.
The economy shrank more than expected in the October-December quarter as flooding in Thailand, a strong yen and weak demand hurt exports, after having rebounded in the third quarter from an earthquake-triggered recession.
But analysts see the fourth-quarter drop as temporary and expect the economy to grow moderately this year helped by reconstruction demand from the March disaster.
The yen weakened against the dollar to a 3- month low of 78.74 yen on Thursday in the wake of the BOJ easing, with the central bank's increased asset buying underlining its resolve to end deflation.
The report upgraded the view on consumer spending for the first time since August. Domestic demand is relatively firm, said Minoru Masujima, director of macroeconomic analysis at the Cabinet Office.
Consumer sentiment has been picking up these last few months, so confidence is recovering after the March disaster.
But the government reiterated that exports have been weakening recently. In its January report it downgraded its assessment of exports for the first time in three months due to the strong yen and with the euro zone debt problems hurting overseas demand.
The government repeated that it will work together with the BOJ to end deflation and expects the central bank to take appropriate and decisive steps.
(Editing by Michael Watson)