The quarterly "tankan" survey's sentiment index for large manufacturers fell from 23 in September to 19, below the 21 mark predicted by analysts. A similar index for large non-manufacturers in the survey, which polls more than 10,000 companies nationwide, fell from 20 to 16. Both figures were the lowest since September 2005.
The indices measure the percentage of companies reporting positive business conditions minus those who are negative. A decline means a growing portion of companies are pessimistic.
Economy Minister Hiroko Ota said a stronger yen, which erodes exporters' overseas income, and rising oil prices weighed on business confidence. But she said the results did not change her view that Japan's economy is on an upward trend.
"The worsening of the BOJ tankan reflects the recent rise in oil, commodities prices and a stronger yen," Ota told a news conference. "These factors must be kept in mind in judging the overall economic trend."
A possible slowdown in the U.S. economy - a key export market - was risk that she was monitoring, she said.
Analysts said the results, along with recent sluggish economic figures, suggest the central bank will hold off from raising interest rates in the near-term as it gauges the American economy and fallout from the subprime mortgage crisis that has rattled global markets.
"The possibility of a rate hike in the near future, which was slim to begin with, have declined further given the results of this report," Lehman Brothers economist Hiroshi Shiraishi said in a note published Friday. Japan's benchmark interest rate was raised to 0.5 percent in February.
Business executives also aren't optimistic about the future. Both large manufacturers and non-manufacturers project their business sentiment indices will drop to 15 in March.
In some positive news, the quarterly survey showed that major companies plan to boost capital investment by 10.5 percent in fiscal 2007, higher than the 8.7 percent increase in September's estimate.
Japan's recent economic indicators have been mixed. Last week, the government said the economy grew at an annual pace of just 1.5 percent, worse than a preliminary estimate of 2.6 percent, due to a a downward revision in capital expenditure figures.
The tankan's results spurred traders to sell the yen, lifting the dollar to 112.32 yen in midafternoon trade from 112.21 yen overnight in New York. In November, the dollar had fallen to a 2 1/2-year low below 108 yen.The stock market's reaction was muted, with the benchmark Nikkei 225 index dipping just 0.14 percent to close at 15,514.51, although it has dropped 3.3 percent over the last three days.