Taylor Rules and the Euro

Abstract

This article uses real‐time data to show that inflation and either the output gap or unemployment, variables which normally enter central banks’ Taylor rules, can provide evidence of out‐of‐sample predictability for the U.S. dollar/euro exchange rate from 1999 to 2007. The strongest evidence is found for specifications that constrain the coefficients on inflation and real economic activity to be the same for the United States and the Euro Area, do not incorporate interest rate smoothing, and do not include the real exchange rate in the forecasting regression. Evidence of predictability is found with both one‐quarter‐ahead and longer‐horizon forecasts.