Output-inflation Tradeoff at Near-zero Inflation Rates

The Japanese CPI inflation rates have been declining since the first quarter of 1991. The CPI inflation rates recorded negative values on the second and third quarters of 1995 and, since then, have been in the narrow range of zero and one percent. Near-zero inflation rates for about four years is an unprecendented experience not only for Japan but also for industrial countries in the postwar period. The purpose of this paper is provide new evidence about the cost of near-zero inflation using the Japanese data. We are interested in whether the relationship between the rate of inflation and the slackness of the economy, i.e. the short-run Phillips curve , depends on the level of inflation rates. We test a hypothesis that the short-run Phillips curve becomes flatter as the rate of inflation approaches zero. In implementing the test, we pay special attention on how to control for other factors affecting the rate of inflation. First, we use the skewness of the distribution of relative-price changes as a measure of supply shocks, expecting that relative-price changes would work better than import-price inflation during the period of "price-destruction" in the first half of the 1990s when disinflation was accelerated by domestic factors such as deregulation in the Japanese distribution system. Second, to control for changes in the expected rate of inflation, we construct a panel data set consisting of the rate of Phillips curve. To be more concrete, we construct a panel data set consisting of the rate of inflation as wall as the ratio of job offers to applicants, in 46 prefectures, 1971 to 1997. Then we transform the observed two variables by subtracting the appropriate national averages, thereby sweeping out the effects of nationwide shocks including changes in expectations about the future course of monetary policy conducted by a single central bank. Though a series of empirical analysis, we find evidences supporting the hypothesis that the slope of the short-run Phillips curve becomes smaller as the rate of inflation approaches zero. In particular, we find that the estimates slope in the 1990s is smaller than before. This regularity holds even when we control for variables such as supply shocks and expected inflation.