Reaction Function
Modelling a central bank — predicting what they'll do before they do it
- Explain the concept of a CB's reaction function
- Identify the inputs each CB weights most heavily
- Predict policy decisions from the data calendar
Imagine you could sit inside the FOMC's head and know exactly which data inputs they care about, and in what order. That's a reaction function — the implicit rule a CB follows. Build it correctly, and you predict decisions before the announcement.
What is a reaction function?
A reaction function is the systematic relationship between a CB's policy rate and the data it watches. The classic Taylor Rule: rate = inflation gap × β1 + output gap × β2 + neutral rate. Modern CBs don't follow it mechanically, but the *spirit* — react to inflation gaps + output gaps — drives every decision.
Reacts to inflation AND employment. Will tolerate higher inflation if jobs are weak, and vice versa. Lower bar to act on jobs than ECB.
Inflation primary. Officially employment is secondary. In practice the ECB looks at growth and labour too, but inflation dominates.
Building your own model
For each CB, list the inputs it cares about and their rough weights. Fed: core PCE, NFP, AHE, ISM, retail sales. ECB: core CPI, PMI, ECB inflation forecast, wages. BoE: services CPI, wages, jobless rate, AHE. When a key input surprises, ask: does this exceed the CB's tolerance band? That's your trade.
Fed targets 2% inflation. Core PCE prints 3.4% (vs 3.2% expected) AND unemployment ticks down 0.1%. Reaction function predicts...
- Reaction function = systematic CB response to data
- Taylor Rule is the textbook starting point
- Each CB weights inputs differently
- Surprise vs the CB's tolerance band = the trade
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