Fundamentals Based Exchange Rate Prediction Revisited

This paper revisits the role of macroeconomic fundamentals as predictors for exchange rate movements at different horizons. It takes seriously the notion that the fundamental dynamics of an economy is hard to measure and that the usual measures, such as monetary aggregates, price index and deflator series and GDP, are imperfect approximations of these fundamental movements. As an alternative measure of underlying fundamental movements of economies, we extract domestic and foreign dynamic I(1) factors from large panels of economic data for Canada, the UK and the US. We show that these domestic and foreign dynamic factors are cointegrated with the US dollar/UK pound sterling and US dollar/Canadian dollar exchange rates. We then rotate these towards the respective exchange rates relative to the US dollar to get an estimate of the ‘fundamental’ or ‘core’ exchange rate levels, which serve as attractors for the actual exchange rates. Using the current deviation between the two as a predictor of future movements for the respective US dollar exchange rates results in successful forecasts.