NATIONAL BUREAU OF ECONOMIC RESEARCH
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The Uncovered Interest Parity Puzzle, Exchange Rate Forecasting, and Taylor Rules

Charles Engel, Dohyeon Lee, Chang Liu, Chenxin Liu, Steve Pak Yeung Wu

NBER Working Paper No. 24059
Issued in November 2017
NBER Program(s):The International Finance and Macroeconomics Program

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.

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Document Object Identifier (DOI): 10.3386/w24059

Published: Charles Engel & Dohyeon Lee & Chang Liu & Chenxin Liu & Steve Pak Yeung Wu, 2018. "The Uncovered Interest Parity Puzzle, Exchange Rate Forecasting, and Taylor Rules," Journal of International Money and Finance, . citation courtesy of

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