Interest rate misalignments and monetary policy: Evidence from U.S. states

Abstract We examine whether a uniform monetary policy effectively addresses diverse state‐level economic conditions in the U.S. Using quarterly data from 1989 to 2017 for 33 states, we construct state‐optimal interest rates based on Taylor rule frameworks incorporating local inflation and unemployment gaps. Deviations from the federal funds rate are large, persistent, and cluster regionally. Local projections show that a 1 pp positive deviation is associated with a 0.6 pp decline in headline inflation and an increase in unemployment, with the strongest effects in non‐tradable sectors. State‐specific deviation shocks elicit larger and longer‐lasting responses than aggregate shocks, underscoring the importance of cross‐sectional heterogeneity.