We show that the underlying source of inflation impacts financial market perceptions of the persistence of monetary policy surprises. Financial markets expect policy surprises to be more persistent when inflation is driven by demand factors. During supply-driven episodes, markets perceive these surprises as less persistent. This divergence in perception arises from markets updating their beliefs about the Fed’s state dependent, or “targeted,” reaction function. Markets infer more information about the Fed’s long-term policy path when surprises occur during periods of large demand imbalances, while they discount this information during supply imbalances. These dynamics lead longer-run interest rates to be more sensitive to variations in demand than supply.
Suggested citation:
Najjar, Rami and Adam Hale Shapiro. 2026. “Not All Inflation Is the Same: State-Dependent Transmission of Monetary Policy.” Federal Reserve Bank of San Francisco Working Paper 2025-28. https://doi.org/10.24148/wp2025-28