Equilibrium Exchange Rates and Exchange Rate Forecasting

Ronald MacDonald University of Strathclyde

Introduction
Main theme of lecture: macroeconomic
fundamentals useful for determination of exchange rates at long (equilibrium) and medium-run (forecasting) horizons. Controversial as seems to go against current conventional wisdom (CCW). What is CCW?

Introduction
CCW argues for the abandonment of
macroeconomic fundamentals for analysing exchange rate movements. CCW takes as its starting point daily volume of global foreign exchange transactions = $1.2 trillion Given on daily basis macro-fundamentals dont change much - How explain $1.2T? Move to Market Microstrucure (MM).

Introduction
MM focuses on institutional features of the
Forex inter-bank behaviour; inter-bank / broker. Two key MM variables are bid-ask measure of transaction costs - and order flow measure of information flow. Theoretical MM literature focuses on det. of B-A and influence of order flow on volatility. Highlights Heterogeneity vs. Homogeneity of expectations Important.

Introduction
Empirical literature provides support for
influence of order flow on volatility-volume and B-A. So perhaps MM helpful for explaining high frequency volatility. But time frame day so not helpful for predictability or equilibrium. The new CCW arose because of the existence of the so-called Exchange Rate Disconnect. This has three aspects:

Introduction
1. Volatility: Exchange rates when flexible are
excessively volatile. Intra- and inter-regime aspects. 2. Level: Exchange rates unpredictable at horizons of < 3 years - relates to forecasting and Meese and Rogoff Random walk result. 3. PPP Puzzle: If PPP taken as measure of equilibrium then equilibrium is ill-defined mean reversion too slow i.e. life too large.

Introduction
I intend focussing on 2 aspects of the
exchange rate disconnect Level and PPP puzzle. Will argue: can forecast currencies using macro fundamentals as short as 2 month horizons; produce sensible measure of equilibrium if abandon PPP and focus on a real exchange rate relationship.

Introduction
The issue of an equilibrium exchange rate, and
the related concept of misalignment, is of interest to policy makers/ central banks/ financial institutions. Forecastability of currencies of interest to financial institutions such as hedge funds. Recently returns from international portfolios have often come from exchange rate movements so getting these right important.

Equilibrium Exchange Rates

Why is the concept of equilibrium of interest? Issues of misalignment in managed float
useful to have indicator for on-going policy debate. Issues of joining a currency union or locking currency to a monetary standard. History replete with example of countries getting this wrong (UK in 1926 and again in 1992)

Equilibrium Exchange Rates

How Measure Equilibrium? Purchasing Power Parity (PPP) first
measure Economists reach for.

S PP
t t t t t t

Q S PP 0
* t

Is it useful? To answer think of derivation.

Equilibrium Exchange Rates

Relies on Law of One Price (LOOP) LOOP Arbitrage + Substitutability Arbitrage: Individual and Wholesale issues
- Are Traded goods Perfectly Substitutable? What Does the Empirical Evidence say? LOOP violated for all but generic goods (i.e. commodities).

Equilibrium Exchange Rates

PPP Puzzle therefore not surprising How explain? Straightforward to decompose real exchange rate:
Qt QtT QtT , NT

i. QT Trading frictions: Impart neutral band Q

follows non-linear process. Quite a bit of evidence in favour of this view but issues of arbitrage and substitutability.

Equilibrium Exchange Rates

ii. Real Factors a) QT,NT Best known
Balassa-Samuelson. TFP shocks in traded sector generates appreciation of CPIbased Q impart systematic trend. Evidence: 1. Indirect: Studies using price data suggest it is movements in QT explain violations of PPP.

Equilibrium Exchange Rates

2. Direct: build TFP from OECD sectoral data
base CPI-based q and qT,NT. Studies report significant evidence of importance of BalassaSamuelson effect + adjustment speeds/ life faster with BS. Real Factors b) QT Failure of LOOP means driven by NFA or TB. A lot of evidence supportive of this + life faster. iii QT Market structure i.e. PTM and pass through. Empirical evidence shows mean reversion speed significantly related to market structure.

Equilibrium: in search of a suitable acronym.

In thinking about equilibrium issues other
approaches take explicitly real perspective. Internal External Balance Best known Fundamental Equilibrium Exchange Rate or FEER. FEER is Q consistent with both internal and external balance in medium run (5 years hence) - not stock-flow equilibrium. IB = high employment + low inflation. EB: sustainable desired net flow of resources between countries when in internal balance.

Equilibrium: in search of a suitable acronym.

Issues with FEER. 1. CAP sustainability controversial - Williamson uses
variety of factors such as Investment needs, effect of demographics on savings. 2. Method of calculation: does not actually say how Q converges to FEER, 3. Depends on underlying trade elasticities very imprecise 4. not clear how good implicit ex rate relationship is. 5. Normative approach. Useful to have approach which separates the behavioural from normative. 6. Micro foundations?

Equilibrium: in search of a suitable acronym.

BEER Approach of Clark and MacDonald
(1999,2000). Sequence: 1. Take standard behavioural real exchange rate model. 2. Use best practice econometrics to estimate model. 3. Use this for assessment purposes - thereby separating positive from normative. General framework for assessment issues. 4. Show real factors important since mean reversion speeds fast: life 1 year or less.

Equilibrium: in search of a suitable acronym.

Permanent Equilibrium Exchange Rates:
PEERs Rely on decomposing Q into permanent and transitory components. Interpret the former as a measure of equilibrium:

where QP permanent component; QT is

transitory. Advantages straightforward. Disadvantages lack of theoretical underpinnings.

Q Q Q
p t t

Equilibrium: in search of a suitable acronym.

A capital enhanced equilibrium exchange
rate, or CHEER [UIP/PPP]. Focuses on x=[s,p,p*,Il, il*] Produces sensible measures of equilibrium in sense that homogeneity restrictions can be imposed on prices and sensible coefficients on idiff. Useful in presence of limited data, but limited in terms of structure.

Equilibrium: in search of a suitable acronym.

New Open Economy Macroeconomic Approach

(NOEM) to Assessment Issues. Basic idea: optimising behaviour of consumers has implications for CA which, in turn, has implications for exchange rates. Optimising rule of consumers suggests elasticity of substitution, , is key determines how relative price of T to NT affects rel quantaties. Given and required in consumption of traded goods show how much of Q needed to restore current balance. Advantages theoretically rigorous. Disadvantages: what is ? and as in FEER normative.

Summary of Equilibrium exchange rate Issues

1. Measure useful for assessment
purposes/ locking currencies together. 2. PPP not a suitable vehicle. Lesson of mean reversion important. 3. Use a measure which makes the normative/ positive split transparent. BEER PEER? 4. Perhaps use a range of indicators and produce weighted average?

Exchange Rate Forecasting

Since Meese and Rogoff (1984) Forecasting
exercises usually defined w.r.t. Random Walk the acid test. Can the profession beat it?

S S
t t 1

A lot of eyeball evidence in favour of

approximate random walk. But issue of time dimension 1, 2 ,3 months? See Figures. Econometric evidence gauges forecastability using RMSE criterion:

Exchange Rate Forecasting

The RMSE criterion is:
( Ft At ) RMSE n
RMSE m RMSE RMSE rw
r
2

How useful? Direction perhaps more so. But this is benchmark in academic literature. How good are the professionals see the
distributions for professionals. From Consensus Economics, period -.

Exchange Rate Forecasting

Econometric work has as starting point study of
Meese and Rogoff (1984) who take variants of the monetary model i.e.:

s f [(m m ),( y y ),(i i )]

* * *

For USD of DM, Yen and , M+R unable to

outperform a random walk at horizons of between one and 12 months ahead Since M+R gave models an unfair advantage random walk very strong.

Exchange Rate Forecasting

Update surveying post M+R: Frankel and Rose (1995) ...the Meese
and Rogoff analysis of short horizons [less than 36 months] has never been convincingly overturned or explained. It continues to exert a pessimistic effect on the field of empirical exchange rate modeling in particular and international finance in general Rogoff (1999) reaffirms this.

Exchange Rate Forecasting

Although Frankel and Rose quote typifies
view in profession, now numerous papers (over 30) using monetary model which have overturned this result: Why discounted? Seems to be view in profession that we need new conventional wisdom mentioned at start of lecture.

Exchange Rate Forecasting

Because of RW result, Obstfeld and Rogoff and
Flood and Rose suggest moving from macro fundamentals to market microstrucure. But does this thrown baby out with bath water? Why the random walk result? M+R and all those who are unable to outperform use simple static models. But exchange market, and underlying, markets inherently dynamic. So should recognise this in any estimation.

Exchange Rate Forecasting

Take MacDonald and Marsh Model UIP/CIP
x=[s,p,p*,Il, il*]

Dynamic:
V=[xt, xt-1, x]

Key advantage of strategy: 1. gives full system of equations, for all variables, rather
than a single reduced form. 2. Facilitates a stringent test of forecast ability since predicted values of all terms (exchange rates, prices and interest rates) are used rather than actual data values.

Exchange Rate Forecasting

Currencies : yen, DM and against USD, Jan
1974 to December 1992, last 24 obs held back for forecasting purposes. The forecasts fully simultaneous and dynamic and could therefore have been used by a potential forecaster. Also significance levels of forecasting performance are provided. Criteria: 1. RMSEr relative to a random walk 2. In terms of directional ability:
(1 if forecast direction = actual,else 0) D n

Exchange Rate Forecasting

Pure Chance: D = 0.5 3. RMSEr Relative to a panel of 150
professional forecasters, located in G7 financial centres, as collected by Consensus Economics of London. Summary of Findings: 1. Able to beat a random walk at horizons as short as 2 months ahead and this continues to longer horizons.

Exchange Rate Forecasting

2. Models have excellent directional ability
on average between 0.6 and 0.7 over the different horizons 3. No forecaster ranks as consistently highly across currencies and/ or horizons.

Exchange Rate Forecasting

The essential point of this modeling: an S
model which has sensible long-run equilibrium and dynamic properties, rich enough to capture the underlying market dynamics, will do better than a static model or one with very simple dynamics. Modelling approach has been used extensively by financial institutions and forecastability seems robust over time.

Summary and Conclusions

Main theme of todays lecture has been to have
argued against the current conventional wisdom in the exchange rate economics literature. Tried to argue that standard macro fundamentals are useful for an analysis of exchange rate behaviour. Specifically we have argued that it is possible to address the Exchange Rate Disconnect.

Summary and Conclusions

Specifically, I argued that PPP on its own is not
a sufficient measure for thinking about equilibrium issues but there are alternatives. These alternatives explicitly recognises that real exchange rates have real determinants. They have an exotic array of mnemonics from BEERs to FEERs to Cheers. Useful for assessment issues and for currency locks.

Summary and Conclusions

We have also argued that the reason so
few researchers have been able to beat a random walk model is because of the very simplistic empirical models used. Realistic dynamic models are able to outperform a random walk and offer good directional performance. Such models should be of use to practitioners.

Summary and Conclusions

In sum, the current trend in the profession
towards market microstructure issues is worthwhile and interesting. However, to abandon a role for macroeconomic fundamentals is tantamount to ignoring key information in the process of exchange rate determination.