The reaction function
Lesson 4 · about 10 min
A central bank's reaction function is the rule, stated or implied, that maps economic data onto policy decisions. "If inflation is above target and unemployment is low, we hold or hike; if unemployment rises sharply, we cut." Every scheduled release is a new input to that function, and the market's job is to work out the new output before the central bank announces it.
Once you understand that the market is trading the reaction function rather than the data itself, a lot of confusing price action becomes legible.
The mandate
Most central banks have a mandate that boils down to price stability, and some add employment. The Federal Reserve has an explicit dual mandate of maximum employment and stable prices, with a 2% inflation target measured on PCE. The ECB and BoE target 2% inflation with employment as a secondary concern. The mandate tells you what the bank is supposed to care about; the reaction function tells you how much it cares about each thing right now.
The reaction function changes
This is the part that catches people. The same data that produced a hike in one year produces a shrug in another, because the bank's weighting has shifted.
| Period (illustrative) | Inflation weight | Employment weight | Financial stability weight | What moved markets most |
|---|---|---|---|---|
| Inflation well above target | Very high | Low | Low | CPI, wages |
| Inflation near target, growth OK | Moderate | Moderate | Low | Everything a little |
| Unemployment rising fast | Low | Very high | Moderate | NFP, claims |
| Banking stress | Low | Low | Very high | Credit spreads, bank stocks |
Traders learn the bank's current weights from the same sources you will study in Module 2: the statement, the press conference, the minutes and the speeches. When a Fed chair says "we are now paying close attention to the labour market," the reaction function has been rewritten, and jobs data just became more important than CPI.
Taylor rules in plain terms
Economists formalise reaction functions with rules of the form:
policy rate = neutral rate + inflation + 0.5 × (inflation − target) + 0.5 × (output gap)
You do not need to compute it. The shape is what matters: the rate should rise more than one-for-one with inflation above target, and rise with the economy running hot. Real central banks deviate from it constantly, but when the market says "the Fed is behind the curve," it means the policy rate is below what a rule like this would suggest.
Key idea: The market trades the central bank's reaction function, not the data. When the bank changes what it is weighing, the same numbers produce different reactions.
Working the function forward
Suppose the reaction function is: cut 25 basis points at each meeting while core inflation is falling and unemployment is at or above 4.3%. Then:
- A hot CPI that stops the "inflation falling" condition takes cuts out of the curve. Two-year yields rise, ES falls (rates channel), the dollar rises.
- An unemployment print of 4.5% adds cuts. Two-year yields fall, ES may rise on rate relief or fall on growth fear depending on how bad the internals are.
- A meeting where the chair says the bank is "less worried about inflation now" loosens the first condition. The whole curve shifts lower before any data changes.
This is why futures markets price meeting-by-meeting probabilities. The CME FedWatch tool, and the equivalent OIS curves for other currencies, show the market's current best guess at the output of the reaction function for each upcoming meeting. Watching those probabilities shift on a release is the most direct measure of how the market interpreted it.
Reaction functions for four banks
| Bank | Formal target | Current practical emphasis (varies) | What the market watches most |
|---|---|---|---|
| Fed | 2% PCE, maximum employment | Whichever side of the mandate is furthest from target | Core PCE, NFP, unemployment rate |
| ECB | 2% HICP | Inflation, with services inflation and wages in focus | Flash HICP, negotiated wages |
| BoE | 2% CPI | Inflation, especially services and wages | CPI, average earnings |
| BoJ | 2% CPI | Achieving sustained inflation and wage growth | Shunto wage rounds, core-core CPI |
The "practical emphasis" column is the bit you have to keep updating. It is the reaction function.
Avoiding the pundit trap
Knowing the reaction function is not the same as knowing what the bank should do. Traders lose money arguing that the Fed is wrong. The bank's decision is the input to your prices, and your job is to forecast that input, not to grade it. Module 6 comes back to this.
Try it: Write the current reaction function of the central bank whose currency you trade in one sentence: "They will [cut/hold/hike] when [condition] and [condition]." Then list the two data series that most directly test those conditions. Those are your must-watch releases for the next month.
Recap
- A reaction function maps data to policy; the market trades its output, not the raw data.
- The function's weights on inflation, employment and financial stability shift over time, and are learned from statements, pressers, minutes and speeches.
- Meeting-by-meeting probabilities from futures and OIS show the market's current estimate of the function's output.
- Forecast the decision; do not grade it.
See it drawn
Original diagrams for the ideas on this page. Illustrative, not real market data.