On the Zero-Inflation Norm of Japanese Firms

From the mid-1990s, when Japan's inflation rate plummeted to a low level, until recently, an increasing portion of firms in the service sector ceased to change their prices. This paper studies the causes of this phenomenon, often referred to as the "zero-inflation norm," and argues that the norm was generated by a fall in the inflation rate and a rise in menu costs. First, using the source data of Japan's official consumer price index (CPI), we document that the emergence of the norm went hand-in-hand with the decline in the inflation rate. Next, we extend the menu cost model of Nakamura and Steinsson [2008] and show that it is able to explain a part of the emergence and disappearance of the norm by changes in the inflation rate, but we emphasize the importance of menu costs for bringing the model close to the data. More precisely, with large and asymmetric menu costs for upward and downward price changes, as implied by the Japanese price data, the model explains about half of the norm. With modest menu costs as implied by the U.S. data, however, the model barely generates the norm at all. Lastly, we study the possibility that model parameters might have changed during the time of the norm. We find that in order for the model to explain the remaining portion of the norm as well as the observed developments in the size of price changes, menu costs and the curvature of the demand curve should have risen, with the former playing a quantitatively important role. Increases in implied menu costs occurred very noticeably in the service sector and less so in the goods sector, lagged the inflation rate decline, and were pronounced for items that saw low inflation rates during the mid-1990s, suggesting the possibility that prevailing low inflation rates and low frequencies of price changes made firms change prices even less frequently than what the standard menu cost model would imply.