A reaction function describes how a central bank systematically adjusts monetary policy in response to changes in the economy — typically inflation and output, and sometimes financial conditions or the exchange rate itself. Markets care about reaction functions because monetary policy works largely through expectations: once investors understand how a central bank is likely to react to incoming data, they price that reaction in advance. Currencies move on the gap between what data imply about the reaction function and what was already priced, not on the policy decision alone.
In 30 seconds
- A reaction function maps economic conditions onto policy decisions.
- It is distinct from forward guidance, which is the communication of the expected path.
- Different central banks react to different variables — know each bank's reaction function.
- Currencies move when data change the implied policy path relative to expectations.
- A shift in the reaction function itself (a "regime change") can move FX for months.
What is a reaction function?
Reaction function: the systematic relationship between the state of the economy and a central bank's policy setting. It describes how the bank reacts to inflation, growth, labour-market conditions and other variables when setting the policy rate.
The classic formalisation is the Taylor rule, which prescribes a policy rate response to deviations of inflation from target and output from potential. Real central banks do not follow a mechanical rule, but they do behave systematically: an inflation-targeting central bank tends to raise rates when inflation rises above target and the economy is strong, and to cut when inflation falls short and the economy weakens. The reaction function is the pattern in that behaviour.
Reaction function vs forward guidance
These concepts are related but distinct. The reaction function is the underlying rule — how the bank responds to data. Forward guidance is the communication of the expected path. A central bank can describe its reaction function to make its guidance more credible, but the two are not the same: guidance tells you what the bank expects to do; the reaction function tells you what it will do if conditions change. For markets, the reaction function is the more durable anchor, because it governs how the bank will respond to surprises.
What each major central bank reacts to
| Central bank | Primary reaction variables | Notable features |
|---|---|---|
| Federal Reserve | Inflation, employment (dual mandate) | Responsive to core inflation and labour-market slack; balance-sheet active |
| European Central Bank | Inflation outlook, underlying inflation | Slower-moving; emphasises persistence; ECB guide |
| Bank of England | Inflation, services inflation, pay growth | Weight on pay and services inflation; BoE guide |
| Bank of Japan | Inflation with policy patience, yen | Very gradual; historically tolerant of low inflation; BoJ guide |
The point is that "the data" is not a single variable. The Federal Reserve's reaction function puts weight on employment as well as inflation; the Bank of England has historically emphasised pay growth and services inflation; the Bank of Japan has tolerated low inflation far longer than its peers. Knowing which variable each bank reacts to is the first step in reading its reaction function.
How to identify a central bank's reaction function
- Read the mandate and strategy review. The stated objective defines the variables. The ECB's 2021 strategy review, for example, explicitly described its reaction function around the inflation outlook and underlying inflation.
- Track the data the bank highlights. The variables that appear repeatedly in statements, minutes and speeches are the reaction-function inputs.
- Map past decisions to data. Which data prints preceded each move? The pattern reveals the weights.
- Watch for threshold language. Phrases like "persistent" or "sustained" reveal the conditions the bank needs to see before acting.
Why reaction functions matter for currencies
Anticipation
Once markets understand a reaction function, they price the likely policy response before the bank moves. A strong inflation print that fits the reaction function may move the currency very little, because the reaction was already priced. A print that changes the reaction function — by suggesting the bank will react more or less aggressively — moves the currency substantially. See why markets trade expectations, not just data.
Regime shifts
Occasionally a central bank changes its reaction function — a new strategy review, a new chair, or a regime change such as a shift to flexible average inflation targeting. These shifts can move currencies for months, because the entire expected path reprices. Read more on regime change in how macro regimes change forex relationships.
Relative reaction functions
FX is relative. If the Fed's reaction function implies faster cuts than the ECB's, the dollar can weaken against the euro on the policy-path gap alone. Comparing reaction functions across banks is the core of policy divergence analysis.
When the relationship breaks
- The bank deviates from its pattern. A surprise dovish or hawkish decision shifts the perceived reaction function and can move the currency sharply.
- Financial conditions dominate. Some banks lean against financial instability, overriding the data-driven reaction.
- The exchange rate enters the function. Some central banks react to the currency itself, especially in emerging markets but also historically at the SNB.
A practical framework
Identify the bank's reaction variables from mandate and statements
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Map recent decisions to those variables to infer weights
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Project the policy path implied by current data
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Compare with market pricing (OIS, OIS)
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Trade the gap — and watch for regime shifts
Common mistakes
- Applying one bank's reaction function to another. The Fed and ECB weight variables differently.
- Confusing guidance with the reaction function. Guidance is the path; the reaction function is the rule behind it.
- Ignoring threshold language. "Persistent" and "sustained" are meaningful conditions, not filler.
Frequently asked questions
Is the Taylor rule the same as a reaction function?
The Taylor rule is one simple formalisation of a reaction function. Real central banks behave systematically but not mechanically, and their weights evolve over time.
Can a central bank change its reaction function?
Yes. Strategy reviews, leadership changes and regime shifts can all alter the weights a bank places on different variables, repricing the entire expected path.
Do reaction functions include the exchange rate?
Sometimes. Most large floating-rate central banks treat the exchange rate as one input among many. Some, including the Swiss National Bank at times, have made the exchange rate a primary instrument.
How this has played out in practice
The European Central Bank's 2021 strategy review is a useful illustration of a reaction function made explicit. The review described the ECB's reaction around three elements — the inflation outlook, the dynamics of underlying inflation, and the monetary policy stance — sometimes summarised as the "ABCs" of the reaction function. By making the inputs explicit, the ECB gave markets a clearer framework for anticipating policy, which in principle reduces volatility around decisions because the reaction is more predictable.
The 2022 inflation shock shows the other side: when inflation surprised far above target, reaction functions across major central banks had to adapt. Banks that had been slow to react because their reaction function emphasised persistence and patience (notably the ECB and Bank of Japan) saw their currencies weaken against banks that reacted faster and more forcefully (notably the Federal Reserve). The currency moved on the perceived shift in each bank's reaction function, not just on the rate decisions themselves. This is the practical content of policy divergence: comparing how systematically each bank responds to the same inflation shock.
What to watch
- Strategy reviews and new leadership, which can reset the weights in a reaction function.
- Threshold language — "persistent", "sustained", "some" — which defines the conditions for action.
- Minutes and speeches for which data the bank is emphasising, since the emphasised variables are the reaction-function inputs.
Putting it together: a worked read
Suppose a central bank holds rates unchanged at a meeting where markets expected a hike, and the currency weakens. The first step is to identify which reaction-function input moved the bank. If the statement emphasises "underlying inflation dynamics" and "the stance", the bank is weighting persistence over the headline — a dovish weighting that markets had underpriced. If the bank cites external risks or financial stability, the reaction function is broader than inflation alone, and the market will re-price to expect more caution ahead. The currency weakness is the market repricing the reaction function, not just the one decision.
Next, check whether the shift is durable. A reaction-function shift driven by a strategy review or new leadership is structural and will persist; one driven by a one-off data wobble is tactical and may reverse. Then compare across central banks: a dovish shift in one bank's reaction function against a hawkish or unchanged peer tilts the relative policy path, which is the FX-relevant signal — see policy divergence. Finally, watch the next data releases through the bank's own lens: if the bank emphasises underlying inflation, the next core-inflation print matters more than the headline. The framework is: identify the emphasised input, judge whether the shift is structural or tactical, compare across banks, and read subsequent data through the bank's own weighting.
Key takeaway
A reaction function is the rule behind a central bank's decisions. Learn which variables each bank reacts to, project the path those variables imply, and trade the gap with market pricing. When the reaction function itself changes, the currency can move for months.
MacroDrivers structures central-bank analysis across eight currencies in one consistent framework. See the methodology.