The Case for Positive Low Inflation: Some Financial Market Considerations with Special Attention to the Problems of Japan

The 1970s witnessed a backlash against inflation. However, Japan's prolonged stagnation and the global economy's recent flirtation with deflation have revived the case for low inflation. Low inflation acts as grease in labor markets, helping the process of adjustment and lowering equilibrium unemployment. It also has beneficial effects on financial markets. There is a "disequilibrium" role for inflation in reducing debt burdens resulting from asset price bubbles. There is also an "equilibrium" role. Low inflation helps avoid the trap of nominal interest rate floors and creates room to reduce real interest rates in recessions. It also reduces the real cost of capital by inducing portfolio substitution away from money, and by lowering the bankruptcy risk associated with deflation.