Working Papers

“Taylor Rules and the Euro ", with Alex Nikolsko-Rzhevskyy and David Papell, March 2008, Full-text

Abstract: This paper uses real-time data to analyze whether the variables that normally enter central banks’ interest-rate-setting rules, which we call Taylor rule fundamentals, can provide evidence of out-of-sample predictability for the United States Dollar/Euro exchange rate from the inception of the Euro in 1999 to the end of 2007. The major result of the paper is that the null hypothesis of no predictability can be rejected against an alternative hypothesis of predictability with Taylor rule fundamentals for a wide variety of specifications that include inflation and a measure of real economic activity in the forecasting regression. The results are robust to whether or not the coefficients on inflation and the real economic activity measure are constrained to be the same for the U.S. and the Euro Area and to whether or not there is interest rate smoothing. Evidence of predictability, however, is only found for specifications that do not include the real exchange rate in the forecasting regression. The evidence of predictability is stronger for real-time than for revised data, about the same with inflation forecasts as with inflation rates, and weakens if output gap growth is included in the forecasting regression. Bad news about inflation and good news about real economic activity both lead to out-of-sample predictability through forecasted exchange rate appreciation.

“Real-Time Exchange Rate Predictability with Taylor Rule Fundamentals", February 2008, Full-text

Abstract: This paper revisits the long-standing Meese and Rogoff puzzle by examining exchange rate predictability with Taylor rule fundamentals and real-time data. Most of the existent literature on exchange rate predictability uses historical data which, because it was not available to the public at the time the forecasts were made, cannot be used to evaluate out-of-sample predictability. Furthermore, most studies of out-of-sample exchange rate forecasting still use 1970’s vintage monetary models. In this paper, I evaluate short-horizon exchange rate predictability using real-time data and Taylor rule fundamentals for 9 OECD currencies, plus the Euro, vis-à-vis the U.S. dollar during the last decade and find strong evidence of exchange rate predictability at the 1-month horizon for 8 out of 10 exchange rates and weak evidence of predictability for the remaining 2 exchange rates. In order to understand how market participants form their exchange rate forecasts, I examine the implications of using different types of real-time data. The evidence of exchange rate predictability is stronger with current-vintage real-time data, which consist of all information available at any given month, than with first-release real-time data, which contain only new information about macroeconomic fundamentals. It is stronger with symmetric Taylor rule models, where the real exchange rate does not appear in the foreign country’s Taylor rule, than with asymmetric models that contain an element of real exchange rate targeting.

“Out-of-Sample Exchange Rate Predictability with Taylor Rule Fundamentals”, with David Papell, revise and resubmit, Journal of International Economics, January 2008, Full-text, Data, and Data Appendix

Abstract: An extensive literature that studied the performance of empirical exchange rate models following Meese and Rogoff’s (1983a) seminal paper has not yet convincingly overturned their result of no out-of-sample predictability of exchange rates. This paper extends the conventional set of models of exchange rate determination by investigating predictability of models that incorporate Taylor rule fundamentals. Using Clark and West’s (2006) recently developed inference procedure for testing the equal predictability of two nested models, we find evidence of short-term predictability for 11 out of 12 currencies vis-a-vis the U.S. dollar over the post-Bretton Woods float. The evidence is much stronger with Taylor rule models than with conventional interest rate, purchasing power parity, or monetary models.

“Taylor Rules with Real-Time Data: A Tale of Two Countries and One Exchange Rate", with Alex Nikolsko-Rzhevskyy and David Papell, forthcoming, Journal of Monetary Economics, June 2008, Full-text

Abstract: Using real-time data that reflects information available to monetary authorities at the time they are formulating policy, we find that estimated Taylor rules based on revised and real-time data differ more for Germany than for the U.S., Taylor rules using real-time data suggest differences between U.S. and German monetary policies, and Taylor rules for the U.S. using inflation forecasts are nearly identical to those using lagged inflation rates. Evidence of out-of-sample predictability for the dollar/mark nominal exchange rate with forecasts based on Taylor rule fundamentals is only found with real-time data and does not increase if inflation forecasts are used.

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