Targeted Taylor rules: some evidence and theory

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

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. The Taylor–type rules used so far to describe central banks' reaction functions assume instead a uniform response of policy rates to inflation irrespective of its drivers. In this paper, we refine the specification of these policy rules to allow for a different (targeted) reaction to demand- versus supply-driven inflation. Estimates of the new targeted rule for the United States show a fourfold larger response to demand-driven inflation than to supply-driven inflation. We use a textbook New Keynesian model to discuss the properties of the new type of monetary policy rule in terms of business cycle fluctuations and welfare.

JEL classification: E12, E3, E52

Keywords: monetary policy trade–offs, targeted Taylor rules, inflation targeting