Exchange rate at 85cents

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The question about economics that I get asked the most is “where is the exchange rate going?” I have been pretty constant in my answer on that one – it is close enough to a random walk (interpret as how the hell would I know if you like). Of course that means that I get it wrong just like everyone else, but the point is, assuming that the exchange rate is a random walk, I don’t get it AS WRONG as the many “currency experts” out there, and I also know that forecasting the exchange rate is a mugs game i.e. I know that I’m going to get it wrong. I’ve copied below a blog post of mine from last year, about a hedge fund manager who predicted that the AUD would have hit $1.70 by now. Not quite as crazy, but still poor in terms of forecasts are the many commentators predicting an AUD at 85c in the next month/few months/year. Quite possibly true, but still a poor forecast relative to the random walk forecast of 97c (or whatever today’s rate is). It is certainly the case that an unexpected early end to QE (currency manipulation) in the US will see the AUD fall – but the point is it is impossible to expect the unexpected.

One clarification that I would make is the point about the exchange rate being close enough to a random walk. The academic debate on this comes down to whether there are long swings in currencies, or whether they are pure random walks. Long swings might mean reversion to a long run mean, which is how I see the exchange rate. The AUD probably has a fundamental of around 80c to 85c. But by long run a good guess is that the half life of shocks is probably somewhere between 3 to 10 years. So if you take the current 97c exchange rate, and assume that the currency takes 7 years to revert half way to the long run fundamental you have a one year ahead exchange rate forecast of {97 – (97-82.5)x0.5 x1/7} = 95.75c…in other words at a year or two you may as well take the random walk forecast and be done with it – the volatility will likely kill you anyway. And the real lessons for business should be don’t try to predict the exchange rate, and expect volatility.

My earlier post follows.

Last July [2011] an attention seeking hedge fund manager predicted that the AUD would be at US1.70 eighteen months from now. Of course anything is possible, but that prediction is now looking even more stupid than it did a year ago. Here is my post about the AUD from one year ago, which I would suggest is holding up pretty well. I still haven’t found Savvas Savouri, I’m guessing he’s gone underground. But I did find this great quote from Reuters about him.

Trusting in hard numbers rather than the forecasts of company managements is key for Toscafund chief economist Savvas Savouri, as he helps one of the UK’s best-known hedge fund firms recover from a tough credit crisis. A self-confessed “data junkie” who claims a number-crunching computer programme he built in the mid-1990s is now the world’s biggest single user of government data, Savouri feeds his colleagues, and his own fund, with his calculations of how much money companies can really make.

I have a pretty good idea what exactly he is feeding his colleagues, and his own fund, but I’ll leave that for you to judge.

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