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The Out-Of-Sample Performance of Empirical Exchange Rate Models

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The Out-Of-Sample Performance of Empirical Exchange Rate Models NBER WORKING PAPER SERIES TAYLOR RULE EXCHANGE RATE FORECASTING DURING THE FINANCIAL CRISIS Tanya Molodtsova David Papell Working Paper 18330 http://www.nber.org/papers/w18330 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 2012 We are grateful to Charles Engel, Jan Groen, Michael McCracken, Barbara Rossi, Michael Rosenberg, Ken West, and participants in seminars at the Bank of France, Paris School of Economics, University of California at Davis, 2010 SEA meetings, 2011 AEA meetings, the Conference on Exchange Rates at Duke University, the 22nd (EC)2 Conference on “Econometrics for Policy Analysis: After the Crisis and Beyond”, and the 2012 ISOM meetings for their comments. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.¸˛¸˛ NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2012 by Tanya Molodtsova and David Papell. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Taylor Rule Exchange Rate Forecasting During the Financial Crisis Tanya Molodtsova and David Papell NBER Working Paper No. 18330 August 2012 JEL No. C22,F31 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. Tanya Molodtsova 1602 Fishburne Dr Department of Economics Emory University Atlanta, GA 30322 [email protected] David Papell Department of Economics University of Houston Houston, TX 77204 [email protected] 1. Introduction The 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 out- of-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-of- sample exchange rate forecasting. Using a Taylor rule with pre-specified coefficients for the inflation differential, output gap differential, and real exchange rate, they construct the interest rate differential implied by the policy rule and use the resultant differential for exchange rate forecasting. We use a single equation version of their model, which we call the Taylor rule differentials model.2 Since there is no evidence that either the Fed or the ECB targets the exchange rate, we do not include the real exchange rate in the forecasting regression for either model.3 1 Gourinchas and Rey (2007) and Engel, Mark, and West (2008) use revised data. Ince (2012) shows that Engel, Mark, and West’s results are stronger with real-time data. Molodtsova and Papell (2009) use quasi-real-time data where the trend does not use ex-post observations, but the data itself incorporates revisions. 2 Taylor (2010b) calls this model the policy rules differential model. 3 Engel, Mark, and West (2012) extend their panel models to include exchange rate factors. They do not include the real exchange rate in their Taylor rule specification. 1 Out-of-sample exchange rate forecasting with Taylor rule fundamentals received blogosphere, as well as academic, notice in 2008. On July 28 and September 9, Menzie Chinn posted on Econbrowser a discussion of in-sample estimates of one of the specifications used in an early version of MNP (2011).4 On August 17, he posted an article by Michael Rosenberg of Bloomberg, who discussed Taylor rule fundamentals as a foreign currency trading strategy. By December 22, however, optimism had turned to pessimism. Once interest rates hit the zero lower bound, they cannot be lowered further. With zero or near-zero interest rates for Japan and the U.S., and predicted near-zero rates for the U.K. and the Euro Area, the prospects for Taylor rule exchange rate forecasting were bleak. A second theme of the post, however, was that there was nothing particularly promising on the horizon. Going back to the monetary model, even in a regime of quantitative easing, faced doubtful prospects for success.5 The events of 2007 – 2009 focused the attention of economists on the importance of financial conditions. On August 9, 2007, the spread between the dollar London interbank offer rate (Libor) and the overnight index swap (OIS), an indicator of financial stress in the interbank loan market, jumped from 13 to 40 basis points on concerns that problems in the subprime mortgage market were spreading to the broader mortgage market.6 The spreads mostly fluctuated between 50 and 90 basis points until September 17, 2008, when they spiked following the announcement that Lehman Brothers had filed for bankruptcy, peaking on October 10 at over 350 basis points. Following the end of the panic phase of the financial crisis in October, 2008, the spread gradually returned to near pre-crisis levels in September 2009. The spread increased again, although not nearly as sharply, in mid-2010 and late-2011. The spreads are depicted in Figure 1. The deteriorating financial situation in late 2007 and 2008 inspired several proposals for linking monetary policy to financial conditions. Mishkin (2008) argued that, when a financial disruption occurs, the Fed should cut interest rates to offset the negative effects of financial turmoil on aggregate economic activity. McCully and Toloui (2008) suggested that, because of tightened financial conditions, the Fed needed to lower the policy rate by 100 basis points in early February 2008 in order to keep the neutral rate constant. Meyer (2008) argued that the Taylor rule without considerations of financial conditions could not explain aggressive Fed policy in early 2008. Taylor (2008) proposed adjusting the systematic component of monetary policy by subtracting a smoothed version of the Libor-OIS spread from the interest rate target that would otherwise be determined by deviations of inflation and real GDP from their targets according to the Taylor rule. He argued that such an adjustment, which would have been about 50 basis points in late February 2008, 4 The results are contained in Chinn (2008). 5 These posts are available on http://www.econbrowser.com/ under “exchange rates”. 6 Taylor and Williams (2009) analyze this episode, calling it a “black swan” in the money market. Thornton (2009) discusses the Libor-OIS spread. 2 would be a more transparent and predictable response to financial market stress than a purely discretionary adjustment. Curdia and Woodford (2010) modify the Taylor rule with an adjustment for changes in interest rate spreads. Using a Dynamic Stochastic General Equilibrium model with credit frictions, they show that incorporating spreads can improve upon a standard Taylor rule, although the optimal size of the adjustment is smaller than proposed by Taylor and depends on the source of variation in the spreads. The spread between the euro interbank offer rate (Euribor) and the euro OIS also jumped in August 2007 and spiked in September and October 2008, although not by as much as the U.S. spread. While the Euribor-OIS spread came down in September 2009, it did not return to its pre-crisis levels. During August and December 2010, the spread jumped to as high as 40 basis points and, in December 2011, reached a maximum of 100 basis points.
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