TOKYO — Japan had a great run in 2006. But as the world's second-largest economy heads into the New Year, it faces a chronic weakness that has dogged it for a decade: anemic consumer spending.

Domestic demand, which accounts for more than half the economy, undercut growth in the latest quarter much more deeply than forecast and forced the government on Tuesday to downgrade its economic outlook.

The slowdown is worrisome because it hits at a perennial weakness that has scuttled previous Japanese economic recoveries, which relied lopsidedly on exports. This time, a similar imbalance is looming.

While robust exports have contributed to record profits at Japanese companies, those profits have yet to spill over into higher wages that will encourage average people to spend more and save less, economists say.

"We just haven't seen wages respond as much as you'd expect to see at this time," said Glenn Maguire, chief economist at Societe Generale in Hong Kong. "Clearly we have a dichotomy between an extremely strong corporate sector and a sluggish household sector."

Japan is hitting the soft patch at a sensitive time, when many are hoping it will be a steady second engine to global growth behind the United States. With the U.S. now poised for its own slowdown, any further weakening in Japan could have wider international ramifications.

FALLING FROM A HIGH

The signs of weakness come after a stellar 2006.

Japanese growth logged its longest expansion since World War II, Tokyo's stock market soared to six-year highs, land prices posted their first increases in more than a decade and deflation was declared all but dead.

But earlier this month, the government announced that weak consumer spending undercut economic growth in the July-September period much worse than previously thought. Instead of growing at an initial estimate of 2 percent in the third quarter, the economy expanded at only a feeble 0.8 percent.

Domestic demand — which includes consumer spending, government spending and private investment — had contracted 0.2 percent from the previous quarter instead of inching up 0.1 percent, as previously thought.

The slump forced the Cabinet Office on Tuesday to downgrade its outlook. It now expects growth of 1.9 percent for the fiscal year ending in March, compared with a forecast of 2.1 percent made just six months ago.

IN A MOOD TO SAVE

Aside from not spending, consumers are saving more.

Japanese have also jacked up savings from 12 percent of income to 14 percent over the course of the year, amid concerns about tax hikes and a government plan to cap consumer loans, said Jesper Koll, chief economist with Merrill Lynch in Tokyo. Spending may pick up only in the first half of next year, he predicted.

A big increase in consumer spending may be late, but many economists as well as Japan's Cabinet Office and the Bank of Japan still expect the overall economy to regain strength in fiscal 2007.

The Cabinet said Tuesday it expects growth of 2 percent, while economists see it as high as 2.75 percent.

Underlining the optimism, the BOJ's quarterly "tankan" survey of forward-looking business sentiment showed that confidence among Japan's largest manufacturers hit a two-year high in December.

But how the BOJ handles interest rates will remain a big wild card.

The central bank raised interest rates in July for the first time in six years to 0.25 percent from virtually zero.

And on Tuesday, the central bank concluded its last policy meeting of the year by leaving its benchmark interest rate unchanged at 0.25 percent, ratcheting expectations for a hike sometime soon.