Questions you dare not ask

Cowen’s Third Law used to read "All propositions about real interest rates are wrong," so I hesitate to tread on this ground.  The question is, when inflation comes, why doesn’t the expectation of that inflation lead to proportional increases in nominal interest rates, thus keeping the real rate constant?  The studies I’ve seen all indicate a less than one-to-one Fisher effect.  I can think of a few hypotheses:

1. People systematically underestimate the forthcoming rate of price inflation.  (Still?)

2. People have generally adaptive expectations, but they will adjust quickly and rationally to big enough jolts.  And maybe inflation rises slowly, but deflations come all of a sudden.  So it seems there are more periods when people’s expectations are lagging an inflation than a deflation, and that will produce the data pattern stated above.

3. People have generally rational expectations in a game against nature, but they are playing a game against the Fed.  The Fed is smarter than the people.  And the Fed has studied Newcomb’s Paradox so it can, on average, figure out when a dose of inflation will surprise people (in a positive way, of course, socially speaking).  So every now and then we get these surprise bursts of inflation, but no comparable surprise bursts of deflation, which of course would not help output any.  In this set-up the Fisher effect won’t fully hold.

4. A Mundell-Tobin effect is operating, so real rates of return are falling because the inflation moves people out of currency and into capital.

5. The new money enters through the loanable funds market, thereby depressing real interest rates.

6. Sometimes things just don’t work out the way you think they ought to.

Once you consider the tax system, you realize how much the cards are stacked against our attempt to explain this.  Many people can deduct their nominal interest payments from their taxes, and that implies we should see a more than one-to-one Fisher effect from inflation.  But we don’t.

You’ll also note that under most of these explanations the specified dose of inflation does not have a significantly negative effect on private savings.  If the inflation is expected, the nominal interest rate adjusts.  If the inflation is not expected, it doesn’t scare off savings.

Do you have other ideas?  I believe the incomplete Fisher effect is a result which holds both across time and across countries, but maybe you know the latest paper which I don’t.