Understanding central banks' reaction functions

Implementing monetary policy is complex as it influences demand, activity and therefore inflation, with varying, and occasionally long, lags. This makes any analysis by central bank watchers a difficult task. Recent economic and financial data are cornerstones of their work, but only really give a very partial picture, however. Therefore, they must be supplemented with prospective analyses based on assumptions about how the economy will respond to monetary impulses. To investors, understanding monetary policy on the basis of quantitative rules such as the Taylor Rule (which analyses the difference between the actual inflation rate and its target level, as well as between the unemployment rate and the equilibrium rate in order to determine the central bank's "optimal" interest rate) is pointless, as it does not consider the delayed effects of previous tightenings. With this in mind (decisions around monetary policy are very qualitative and are not governed by rules), understanding central banks' reaction functions is essential. Three distinct areas need to be considered in order to achieve this understanding: i. which variables are taken into account during central bank discussions? ii. how does the central bank respond to new information? iii. what will the future trends in data seen as crucial by the central bank be?

Recent statements from Jerome Powell and Christine Lagarde give a clearer picture for the first of these three areas. The Chair of the Federal Reserve has stated that the Federal Reserve is focusing on four factors: the cumulative increase in official rates, delays in the transmission of monetary policy, economic and financial developments, and recent economic data. The ECB is primarily interested in new economic and financial data, the underlying inflation dynamic and the strength of monetary policy transmission. Unsurprisingly, these two lists of priorities are very similar, as the US and eurozone economies operate in more or less the same way. However, there is a fairly clear difference in how each of the institutions reacts to new information. In his recent press conference, Jerome Powell took the view that the Federal Reserve's monetary policy could already be restrictive enough. However, following the ECB governing council's meeting, Christine Lagarde stressed that it would be premature to pause its tightening and that there was still ground to cover to arrive at a monetary policy stance that would achieve the inflation target. The disparity in these institutions' messages, despite their very similar reaction functions, shows how the Federal Reserve's tightening cycle is at a more advanced stage, with the Federal Funds rate significantly higher than the ECB deposit facility rate in particular. Another factor that should be taken into account is the tightening of bank lending conditions, which, compared to historic levels, is far sharper in the United States than in the eurozone. In addition, the recent problems in some US regional banks have increased the sense of unease among Federal Reserve Governors. During his press conference, Jerome Powell reiterated that lending conditions were deteriorating, and that a recent survey of loan officers confirmed that the trend was becoming more pronounced, particularly within medium-sized banks. Historically, a significant tightening in conditions for granting loans in the United Stated had preceded a drop in company investment and household residential investment volumes. The same can also be said about the relationships between these variables in the eurozone. The current situation in the United States is reminiscent of May 2000, when the Federal Reserve halted the hikes in its rates, despite job creation figures standing above 300,000 on average per month during the first quarter. However, it became more difficult for companies to access loans. This experience shows that any analysis of central banks' reaction functions (and, therefore, any forecasting of their decisions) must properly identify the key variables, considering the specific characteristics of the current cycle. Inflation and the labour market are important criteria, but lending conditions are equally key.  

Reproduced with the kind authorisation of L'AGEFI