Taylor rule deviations and out-of-sample exchange rate predictability

Onur Ince, Tanya Molodtsova and David Papell

Journal of International Money and Finance, 2016, vol. 69, issue C, 22-44

Abstract: The Taylor rule has become the dominant model for academic evaluation of out-of-sample exchange rate predictability. Two versions of the Taylor rule model are the Taylor rule fundamentals model, where the variables that enter the Taylor rule are used to forecast exchange rate changes, and the Taylor rule differentials model, where a Taylor rule with postulated coefficients is used in the forecasting regression. We use data from 1973 to 2014 to evaluate short-run out-of-sample predictability for eight exchange rates vis-à-vis the U.S. dollar, and find strong evidence in favor of the Taylor rule fundamentals model alternative against the random walk null. The evidence of predictability is weaker with the Taylor rule differentials model, and still weaker with the traditional interest rate differential, purchasing power parity, and monetary models. The evidence of predictability for the fundamentals model is not related to deviations from the original Taylor rule for the U.S., but is related to deviations from a modified Taylor rule for the U.S. with a higher coefficient on the output gap. The evidence of predictability is also unrelated to deviations from Taylor rules for the foreign countries and adherence to the Taylor principle for the U.S.

Keywords: Exchange rates; Out-of-sample exchange rate predictability; Taylor rules (search for similar items in EconPapers)
JEL-codes: E5 F3 (search for similar items in EconPapers)
Date: 2016
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (14)

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Working Paper: Taylor Rule Deviations and Out-of-Sample Exchange Rate Predictability (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:69:y:2016:i:c:p:22-44

DOI: 10.1016/j.jimonfin.2016.06.002

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