Mar

10

Exchange Rate forecasts

March 10, 2009 | 4 Comments | Mark Crosby

I believe that one of the most robust empirical results in macroeconomics is the idea that the nominal exchange rate is a random walk (for floating exchange rate countries).  In two papers in 1983, Meese and Rogoff found that no existing structural exchange rate model could reliably out predict the random walk alternative at short to medium term horizons, even when aided by actual future values of the regressors!!  Not surprisingly there has been a huge literature trying to overturn this result, but nothing convincingly overturns this result for exchange rates such as the AUD/USD. I don’t think this result is very surprising – billions of $ are traded on FX markets every day – it is about the perfect example of a thickly traded market, where arbitrage opportunities are instantaneously removed by traders, so it would be surprising if there were predictability at horizons of a year or two. Despite the random walk result, I consistently see private forecasters providing (dumb) forecasts that violate the random walk model. 

In the last week I have seen forecasts from both ANZ and Westpac that have the AUD/USD rate at 55c next year, against the current roughly 63c. The random walk forecast is 63c – today’s exchange rate – at least for the next 18 months to two years. Forecasters need to explain that the random walk is the best forecast, and that this point estimate of the future value of the exchange rate will almost certainly be wrong! The exchange rate is very volatile. So it will likely move by 10 to 15c (or more) in the next year or so. But whether it moves up or down is unpredictable. Businesses need to take actions to ensure that they are able to cope with large movements in the exchange rate, and business should never count on a movement in any direction in the exchange rate. Private forecasting models that assume predictable movements in the exchange rate are not defensible. Westpac has been sued before on the basis of implicit forecasts for the Swiss franc AUD exchange rate that assumed that the exchange rate is not volatile. In my opinion putting out non-random walk exchange rate predictions is equally silly. Point forecasts for the exchange rates are dangerous enough, adding in biased forecasts is asking for trouble.


Comments

4 Responses to “Exchange Rate forecasts”

  1. Mark Heydon on March 10th, 2009 8:23 pm

    I don’t agree completely on the random walk – currency markets tend to move in the opposite direction to the position I’m holding.  I am currently long GBP and sure enough, the AUD/GBP is falling.

  2. Joe Yap on March 12th, 2009 10:56 am

    Thanks for the insight. From now on, my standard response to discussions that start veering into currency forecasting will be to yell “Meese and Rogoff!” and disappear in a puff of smoke shrouded by a red cloak.

  3. Christine Neill on March 12th, 2009 3:47 pm

    Wasn’t there an RBA paper of a few years ago that claimed that you could forecast the $A better if you incorporated commodity prices?  Can’t find it now, but have vivid memories of it saying that in effect money was being left on the table.  I did, though, find a paper by <a href = “http://www.nber.org/digest/jul08/w13901.html”>Chen, Rogoff and Rossi</a> that (I think from a skim of the abstract) says commodity currencies are good forecasters of future commodity prices, but not the other way round.

    On balance, the inverse Mark Heydon method sounds like a better bet, still.

  4. Mark Crosby on March 12th, 2009 4:27 pm

    The problem is that commodity prices are also random walks, so not much use in terms of forecasting. Take a look at Amy Auster’s piece in today’s AFR on ANZs exchange rate forecasts. Then go to the ANZ research page and look at their forecasts from mid last year – they were forecasting the AUD/USD at $1.03 before a gradual retreat to 88c in a few years. Again, an inferior forecast to a random walk at the 1 to 2 year horizon - my point is that we should admit what is not forecastable rather than giving poor advice. Having said all that can you keep us informed of your positions Mark!