The uncovered interest parity puzzle, exchange rate forecasting, and Taylor rules. (July 2019)

• Record Type: Journal Article
• Authors: Engel, Charles; Lee, Dohyeon; Liu, Chang; Liu, Chenxin; Wu, Steve Pak Yeung
• Is Part Of: Journal of international money and finance. Volume 95(2019)
• Page Start: 317
• Page End: 331
• Publication Date: 2019-07
• Subjects: Uncovered interest parity puzzle -- Exchange rate forecasting -- Taylor rules -- Liquidity; F3 -- F31 -- F41; International finance -- Periodicals; Foreign exchange -- Periodicals; Finances internationales -- Périodiques; Change -- Périodiques; Foreign exchange; International finance; Periodicals; 332.04205
• DOI: 10.1016/j.jimonfin.2018.03.008
• Languages: English
• ISSNs: 0261-5606

Abstract

Abstract: 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.