Equilibrium Exchange Rates and Exchange Rate Forecasting

1
Equilibrium Exchange Rates and Exchange Rate
Forecasting

• Ronald MacDonald
• University of Strathclyde

2
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?

3
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).

4
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.

5
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

6
Introduction

• 1. Volatility Exchange rates when flexible are
  excessively volatile. Intra- and inter-regime
  aspects.
• 2. Level Exchange rates unpredictable at
  horizons of lt 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. ½ life too large.

7
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.

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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.

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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)

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Equilibrium Exchange Rates

• How Measure Equilibrium?
• Purchasing Power Parity (PPP) first measure
  Economists reach for.
• Is it useful? To answer think of derivation.

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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).

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Equilibrium Exchange Rates

• PPP Puzzle therefore not surprising How explain?
• Straightforward to decompose real exchange rate
• 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.

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Equilibrium Exchange Rates

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

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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 Balassa-Samuelson
  effect adjustment speeds/ ½ life faster with
  BS.
• Real Factors b) QT Failure of LOOP means driven
  by NFA or TB. A lot of evidence supportive of
  this ½ life faster.
• iii QT Market structure i.e. PTM and pass
  through. Empirical evidence shows mean reversion
  speed significantly related to market structure.

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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.

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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?

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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 ½ life 1 year or less.

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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.

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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.

20
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, s, is key determines how
  relative price of T to NT affects rel quantaties.
• Given s and required ? in consumption of traded
  goods show how much of ?Q needed to restore
  current balance.
• Advantages theoretically rigorous. Disadvantages
  what is s? and as in FEER normative.

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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?

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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?
• 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

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Exchange Rate Forecasting

• The RMSE criterion is
• 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 -.

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Exchange Rate Forecasting

• Econometric work has as starting point study of
  Meese and Rogoff (1984) who take variants of the
  monetary model i.e.
• For USD of DM, Yen and , MR unable to
  outperform a random walk at horizons of between
  one and 12 months ahead
• Since MR gave models an unfair advantage
  random walk very strong.

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Exchange Rate Forecasting

• Update surveying post MR
• 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.

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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.

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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? MR 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.

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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.

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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

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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.

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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.

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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.

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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.

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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.

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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.

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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.