Targeted Taylor Rules: Some Evidence and Theory

Abstract

We introduce targeted Taylor rules: monetary policy rules which allow for different reactions to demand– and supply–driven inflation. This new concept aligns with the strategy of the Federal Reserve — as reflected in its official communications. Estimates of this new type of rule suggest that U.S. monetary policy has reacted nearly fourfold more strongly to demand– than to supply–driven inflation since Paul Volcker’s Chairmanship. These results obtain both when using off–the–shelf decompositions of inflation in demand and supply factors, as well as novel measures of demand– and supply–driven inflation derived with an advanced reasoning Large Language Model (LLM) applied to FOMC transcripts. We show how to embed this new type of rule into a New-Keynesian model with simultaneous demand and supply shocks, and discuss its implications for business cycle fluctuations and welfare.

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