Targeted Taylor rules: some evidence and theory
(December 2024, revised September 2025)
Summary
Focus
We refine the monetary policy rules used to summarise central banks' reaction functions to allow for a different (targeted) reaction to demand- versus supply-driven inflation. We estimate this novel type of rule for the United States and discuss its business cycle properties through the lens of a textbook monetary model.
Contribution
Monetary theory and central bank doctrine generally prescribe a forceful reaction to demand-driven inflation and an attenuated response, if any, to supply-driven inflation. Taylor-type rules used to describe how central banks set policy rates in practice assume instead a uniform response to inflation regardless of its drivers. We refine the specification of these rules to allow for a different response based on the type of inflation and refer to this new type of rule as a targeted Taylor rule.
We estimate such a rule for the United States. To do so, we estimate a Taylor-type rule where we replace overall inflation with its demand- and supply-driven components. We then introduce the new type of rule in a textbook monetary model to study its properties in terms of business cycle fluctuations and welfare.
Findings
Our main findings are threefold. First, over the past four decades, the response of US monetary policy to demand-driven inflation has been significantly larger than that to supply-driven inflation. Second, simulations from our theoretical model show that output and inflation display very different business cycle properties when the central bank follows the estimated targeted Taylor rule instead of the conventional one. Finally, we find that a targeted rule can always approximate optimal policy better than a conventional rule when business cycle fluctuations are driven by both demand and supply factors.
Abstract
The paper introduces the concept of a targeted Taylor rule defined as a monetary policy rule which allows for different responses to demand– and supply–driven inflation. This new concept tallies with Federal Reserve's monetary policy strategy as reflected in its official communications. When estimated for the United States using recent decompositions of inflation in demand and supply factors, this new type of rule points to an almost fourfold stronger monetary policy reaction to demand– than to supply–driven inflation starting with Paul Volker's Chairmanship. We show how to embed the new targeted rule into a textbook New-Keynesian model when the economy is simultaneously hit by demand and supply shocks, and discuss its implications for business cycle fluctuations and welfare.
JEL classification: E12, E3, E52
Keywords: monetary policy trade–offs, targeted Taylor rules, inflation targeting
