Exchange Rates and Fundamentals: Footloose or Evolving Relationship?

Using novel real-time data on a broad set of economic fundamentals for …ve major US dollar exchange rates over the recent ‡oat, we employ a predictive procedure that allows the relationship between exchange rates and fundamentals to evolve over time in a very general fashion. Our key …ndings are that: (i) the well-documented weak out-of-sample predictive ability of exchange rate models may be caused by poor performance of modelselection criteria, rather than lack of information content in the fundamentals; (ii) the di¢ culty of selecting the best predictive model is largely due to frequent shifts in the set of fundamentals driving exchange rates, re‡ecting swings in market expectations over time. However, the strength of the link between exchange rates and fundamentals is di¤erent across currencies. JEL classi…cation: F31.