The uncovered interest parity puzzle, exchange rate forecasting, and Taylor rules

Recent research has found that the Taylor-rule fundamentals have power to forecast changes in U.S. dollar exchange rates out of sample. Our work casts some doubt on that claim. However, we find strong evidence of a related in-sample anomaly. When we include U.S. inflation in the well-known uncovered...

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Bibliographic Details
Published inJournal of international money and finance Vol. 95; pp. 317 - 331
Main Authors Engel, Charles, Lee, Dohyeon, Liu, Chang, Liu, Chenxin, Wu, Steve Pak Yeung
Format Journal Article
LanguageEnglish
Published Elsevier Ltd 01.07.2019
Subjects
Exchange rate forecasting
Liquidity
Taylor rules
Uncovered interest parity puzzle
Taylor rules
F41
Exchange rate forecasting
F31
Liquidity
F3
Uncovered interest parity puzzle
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Summary:Recent research has found that the Taylor-rule fundamentals have power to forecast changes in U.S. dollar exchange rates out of sample. Our work casts some doubt on that claim. However, we find strong evidence of a related in-sample anomaly. When we include U.S. inflation in the well-known uncovered interest parity regression of the change in the exchange rate on the interest-rate differential, we find that the inflation variable is highly significant and the interest-rate differential is not. Specifically, high U.S. inflation in one month forecasts dollar appreciation in the subsequent month. We introduce a model in which a Taylor rule determines monetary policy, but in which not only monetary shocks but also liquidity shocks drive nominal interest rates. This model can potentially account for the empirical findings.
ISSN:0261-5606
1873-0639
DOI:10.1016/j.jimonfin.2018.03.008