Taylor Rule Exchange Rate Forecasting During the Financial Crisis

Abstract

This paper evaluates out-of-sample exchange rate predictability of Taylor rule models, where the central bank sets the interest rate in response to inflation and either the output or the unemployment gap, for the euro/dollar exchange rate with real-time data before, during, and after the financial crisis of [2008][2009]. While all Taylor rule specifications outperform the random walk with forecasts ending between 2007:Q1 and 2008:Q2, only the specification with both estimated coefficients and the unemployment gap consistently outperforms the random walk from 2007:Q1 through 2012:Q1. Several Taylor rule models that are augmented with credit spreads or financial condition indexes outperform the original Taylor rule models. The performance of the Taylor rule models is superior to the interest rate differentials, monetary, and purchasing power parity models. IntroductionThe past few years have seen a resurgence of academic interest in out-of-sample exchange rate predictability. Gourinchas and Rey (2007), using an external balance model, Engel, Mark, and West (2008), using monetary, Purchasing Power Parity (PPP), and Taylor rule models, and Molodtsova and Papell (2009), using a variety of Taylor rule models, all report successful results for their models vis-à-vis the random walk null. There has even been the first revisionist response. Rogoff and Stavrakeva (2008) criticize the three above-mentioned papers for their reliance on the Clark and West (2006) statistic, arguing that it is not a minimum mean squared forecast error statistic.An important problem with these papers is that none of them use real-time data that was available to market participants. 1 Unless real-time data is used, the "forecasts" incorporate information that was not available to market participants, and the results cannot be interpreted as successful out-of-sample forecasting. Faust, Rogers, and Wright (2003) initiated research on out-of-sample exchange rate forecasting with real-time data. Molodtsova, Nikolsko-Rzhevskyy, and Papell (2008) use real-time data to estimate Taylor rules for Germany and the U.S. and forecast the deutsche mark/dollar exchange rate outof-sample for 1989:Q1 -1998:Q4. Molodtsova, Nikolsko-Rzhevskyy, and Papell (2011), henceforth MNP (2011), use real-time data to show that inflation and either the output gap or unemployment, variables which normally enter central banks' Taylor rules, can provide evidence of out-of-sample predictability for the U.S. Dollar/Euro exchange rate from 1999 to 2007. Adrian, Etula, and Shin (2011) show that the growth of U.S. dollar-denominated banking sector liabilities forecasts appreciations of the U.S. dollar from 1997 to 2007, but their results break down in 2008 and 2009. Molodtsova and Papell (2009) conduct out-of-sample exchange rate forecasting with Taylor rule fundamentals, using the variables, including inflation rates and output gaps, which normally comprise Taylor rules. Engel, Mark, and West (2008) propose an alternative methodology for Taylor rule out-ofsample exchange rate forecas...

The dollar–euro exchange rate and monetary fundamentals

“…Recent studies by Engel et al (2008) and Ince, Molodtsova, and Papell (2015) rely on the monetary approach as a benchmark when evaluating the out-of sample performance of fundamental exchange rate models. Our results are also consistent with the findings of Molodtsova and Papell (2013) who evaluate the Euro/U.S. dollar rate out-of-sample during the financial crisis using a range of different models.…”

Macro Approaches to Foreign Exchange Determination

“…This is true at the onemonth horizon, as well as longer horizons up to one year. 26 Molodtsova and Papell (2010) show that these results largely survive the arrival of zero interest rate policy to the US and the euro area. 27 Benigno (2004), Corsetti, Dedola, Leduc (2010) and Engel, West and Zhu (2010) show that monetary policy rules that can, among other things, generate some of the observed production function based approaches.…”

Currency Options, Implied Interest Rates and Inflation Targeting

“…Capistran and Ramos-Francia (2010) find that the dispersion of inflation forecasts is smaller under inflation targeting regimes across fourteen inflation targeting countries. Arizmendi (2013) merges the inflation targeting model proposed by Taylor (1993) and Molodtsova and Papell (2012) with the Garman-Kohlhagen option pricing model. He demonstrates how the target interest rate can be incorporated directly into the option price, allowing the option price to reflect the domestic interest rate targets and the inflation targets of the central bank.…”

“…11, No. 2;2019 Notes Note 1. Surveys on market expectations of inflation are gathered monthly, if not quarterly, for most economies.…”