Predict which way a central bank is likely to respond to new data and explain how MAS policy works differently.
When a new piece of economic data comes out, ask how the central bank is likely to respond to it, because markets price that response in before the bank says a word. The pattern you are reading is the bank's reaction function: how it tends to respond to the data it cares about. Knowing it lets you anticipate which way policy will go without forecasting anything, and it explains moves in your own holdings that would otherwise look random.
Marcus, an investor in Singapore, owns a bond fund, a chip stock and a world ETF. The chip stock and the world ETF are priced in US dollars. Late on a Friday (the timing is an example), the US releases a jobs report that is far stronger than expected. When Marcus checks on Monday morning in Singapore, the bond fund has dropped, the chip stock has dropped, and the US dollar has gained.
The Fed made no comment over the weekend. Traders worked out what the Fed would probably do, using the way it has behaved for years, and moved prices to match. A strong jobs report points to a tight labour market, so markets expected US rates to remain high for longer. With that expectation priced in, bond prices and growth stocks like Marcus's chip stock fell and the US dollar climbed.
A reaction function is something you piece together yourself. The bank does not follow it mechanically as a formula. You build it from three sources: the bank's mandate, what it says in its statements, and what it has decided in the past.
Economists often boil a reaction function down to a simple rule, and the most widely known is the Taylor rule, proposed by economist John Taylor in 1993. In one common version, the policy rate is the sum of four parts: the neutral real rate, current inflation, half of (inflation minus target), and half of (actual output minus potential output). That last bracket is called the output gap. When the economy is producing below its potential, the gap is negative.
To work it through, begin with the neutral real rate and add current inflation. Next, add half of the amount by which inflation differs from the target. Last, add half of the output gap, which means subtracting when the gap is negative.
Suppose the neutral real rate is 0.5%, inflation is 3% and the target is 2%, with the economy running at potential so the output gap is zero (invented inputs). The rule gives 0.5 + 3 + half of 1 + 0 = 4.0%. Now let inflation rise to 4% while the economy slips 1% below potential, giving an output gap of minus 1%. The neutral real rate is still 0.5% and the target is still 2%. The rule now gives 0.5 + 4 + half of 2 - half of 1 = 5.0%. Weaker growth was pulling the suggested rate down, yet it still went from 4.0% to 5.0%. Under the rule, higher inflation pushes the rate up by more than one for one, while weaker growth pushes it down.
No central bank actually sets its rate with the Taylor rule. Its inputs are estimates, and people disagree about them. Treat its answer as a guide to which way a rate might move and roughly how far, and avoid reading it as a prediction of the real rate.
Congress gave the Federal Reserve a dual mandate: maximum employment and stable prices. The Fed's own definition of price stability is inflation of 2% over time, measured by the personal consumption expenditures (PCE) price index. Its main tool is the target range it sets for the federal funds rate.
With that mandate, inflation and the labour market come first for the Fed. When inflation sits above target and the labour market is tight, the Fed leans towards raising rates or putting off cuts. When unemployment climbs and inflation cools, it leans towards cutting.
A reaction function can shift over time. In 2021 the Fed described rising inflation as largely transitory and kept rates near zero. Inflation kept rising, so the Fed changed course and raised rates very quickly through 2022. Investors who expected the 2021 behaviour to carry on were caught out.
Rates in Singapore track US rates closely. Fed moves pass through into SORA, the overnight rate that many Singapore loans are now priced from. Lesson 2.2 of "How the economy hits your wallet: rates, inflation and cycles", titled "What SORA is and how it ends up in your mortgage", follows that path in detail, from the Fed to Singapore loans and mortgages.
MAS does not set an interest rate. It manages the Singapore dollar against a trade-weighted basket of the currencies of Singapore's main trading partners, keeping it inside a policy band whose exact position it does not disclose. MAS can adjust three settings of that band: the slope, meaning the pace at which the band appreciates or depreciates; the width; and the level of the centre. Lesson 1.2 of "How the economy hits your wallet", titled "Slope, width and centre: how the policy band works", goes through each of the three.
Inflation and growth sit at the centre of MAS's reaction function too. When MAS core inflation runs high, MAS tends to steepen the slope or re-centre the band upward, letting the Singapore dollar strengthen faster. A stronger Singapore dollar makes imports cheaper. When growth weakens sharply and inflation is low, MAS tends to flatten the slope. As inflation rose in 2021 and 2022, MAS tightened several times, and some of those moves came between its scheduled policy statements.
As an investor, what you care about in MAS policy is how it affects the currency. A steeper slope tells you MAS intends the Singapore dollar to rise faster. For Marcus, whose world ETF and chip stock are priced in US dollars, a faster-rising Singapore dollar would steadily drag on their returns measured in SGD. You can see this in the currency part of the formula from lesson 1.3, "Returns in Singapore dollars when the asset is priced in US dollars".
Whenever a data release lands, go through these in order:
Does this push inflation or jobs away from what the central bank wants? Which way would the central bank's reaction function respond? Was this already expected?
The last question matters because prices react to the surprise rather than to the release itself. A strong number that everyone was already expecting may barely move anything. Marcus's holdings moved because the jobs report came in far stronger than expected.
Reading reaction functions will not tell you what to buy. What it gives you is the reason your holdings moved on a day when there was no news about them.
For the activity, open the latest MAS monetary policy statement on the MAS website. Find what it says about the slope, width and centre of the band and why, then write two sentences on what it signals for the Singapore dollar.
Read the most recent MAS monetary policy statement and write two sentences on what it signals for the Singapore dollar.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).