Working Paper: CEPR ID: DP9575
Authors: Barbara Rossi
Abstract: The main goal of this article is to provide an answer to the question: "Does anything forecast exchange rates, and if so, which variables?". It is well known that exchange rate fluctuations are very difficult to predict using economic models, and that a random walk forecasts exchange rates better than any economic model (the Meese and Rogoff puzzle). However, the recent literature has identified a series of fundamentals/methodologies that claim to have resolved the puzzle. This article provides a critical review of the recent literature on exchange rate forecasting and illustrates the new methodologies and fundamentals that have been recently proposed in an up-to-date, thorough empirical analysis. Overall, our analysis of the literature and the data suggests that the answer to the question: "Are exchange rates predictable?" is, "It depends" on the choice of predictor, forecast horizon, sample period, model, and forecast evaluation method. Predictability is most apparent when one or more of the following hold: the predictors are Taylor rule or net foreign assets, the model is linear, and a small number of parameters are estimated. The toughest benchmark is the random walk without drift.
Keywords: exchange rates; forecast evaluation; forecasting; instability
JEL Codes: C5; F3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Taylor rule (E43) | exchange rate predictability (F31) |
| net foreign assets (F30) | exchange rate predictability (F31) |
| traditional economic predictors (P17) | exchange rate predictability (F31) |
| random walk model (C69) | exchange rate predictability (F31) |
| linear models (C29) | exchange rate predictability (F31) |
| Taylor rule fundamentals (E43) | out-of-sample forecasting ability (C53) |
| predictors vary in effectiveness (C52) | predictability (D84) |