You will be able to predict the direction of a central bank's response to data and explain how MAS policy differs.
On a Friday night a US jobs report comes out far stronger than expected. By Monday morning in Singapore, Marcus's bond fund is down, his chip stock is down and the US dollar is up. Nobody at the Fed has said anything yet. Markets moved because they guessed what the Fed would now do, and they guessed it from a pattern the Fed has shown for years. That pattern is called a reaction function, and learning to read it lets you anticipate the direction of policy without forecasting anything.
A reaction function is how a central bank tends to respond to the data it cares about. It isn't a formula the bank follows mechanically. It's the pattern you can infer from its mandate, its statements and its past decisions.
Economists summarise it with simple rules. The best known is the Taylor rule, proposed by the economist John Taylor in 1993. One common version says the policy rate should equal a neutral real rate, plus current inflation, plus half the gap between inflation and the target, plus half the gap between actual and potential output.
Here it is with made-up inputs. Say the neutral real rate is 0.5%, inflation is 3%, the target is 2% and the economy is running at its potential. The rule suggests 0.5, plus 3, plus half of 1, plus zero: 4.0%. Now push inflation to 4% and let the economy slip slightly below potential, with an output gap of minus 1%. The rule suggests 0.5, plus 4, plus half of 2, minus half of 1: 5.0%.
No central bank sets rates this way, and the inputs are themselves estimates that people argue about. The value of the rule is that it shows direction and size: higher inflation pulls the rate up by more than one for one, and weaker growth pulls it down.
The Federal Reserve has a dual mandate set by Congress: maximum employment and stable prices. It defines price stability as inflation of 2% over time, measured by the personal consumption expenditures price index, and it acts mainly by setting a target range for the federal funds rate.
So the Fed watches inflation and the labour market above all. Data that shows inflation running above target and a tight labour market pushes it towards higher rates or delays cuts. Data that shows rising unemployment and cooling inflation pushes it the other way.
The reaction function can shift. In 2021 the Fed described rising inflation as largely transitory and held rates near zero. When inflation kept climbing, it reversed course and raised rates very quickly through 2022. Investors who assumed the 2021 pattern would hold were caught out.
Because Singapore's interest rates follow US rates closely, Fed moves flow into SORA, the overnight rate that many Singapore loans are now priced from. How the economy hits your wallet: rates, inflation and cycles explains how, in lesson 2.2, What SORA is and how it ends up in your mortgage.
MAS doesn't set an interest rate. It manages the Singapore dollar against a trade-weighted basket of currencies of Singapore's main trading partners, keeping it inside an undisclosed policy band. It adjusts three settings: the slope, which sets 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, Slope, width and centre: how the policy band works, explains each one.
MAS's reaction function centres on inflation and growth too. When MAS core inflation runs high, it tends to steepen the slope or re-centre the band upward, letting the Singapore dollar strengthen faster, which makes imports cheaper. When growth weakens sharply and inflation is low, it tends to flatten the slope. In 2021 and 2022, as inflation rose, MAS tightened several times, including moves between its scheduled policy statements.
For an investor, the useful part is the effect on currency. A steeper slope means MAS intends a faster-rising Singapore dollar. For Marcus, whose world ETF and chip stock are priced in US dollars, a faster-rising Singapore dollar is a steady drag on SGD returns, through the currency part of the formula in lesson 1.3, Returns in Singapore dollars when the asset is priced in US dollars.
Put the pieces together. When a data release comes out, ask three questions: does this push inflation or jobs away from what the central bank wants, which way would its reaction function respond, and was this already expected? Markets move on the surprise, not the release. If the jobs report was strong but everyone expected it, prices may barely move.
None of this tells you what to buy. It tells you why your holdings moved on a day with 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, and write two sentences on what it signals for the Singapore dollar.
Read the latest 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).