Exchange rate dynamics and forecast errors about persistently changing fundamentals

This paper offers and tests a novel explanation for the exchange rate determination puzzle. It is not that fundamentals do not drive exchange rates, but rather, when fundamentals undergo persistent changes, it is important to measure their effect in terms of how they change relative to what was expected. This result is demonstrated with a simple model and then tested using interest rate forecast data from nearly 50 major banks. The I(2) Cointegrated VAR is used to more adequately address non-stationarity; allowing for time varying trends and more elaborate driving and adjustment dynamics. In the preliminary results for the British pound US dollar sample, there is clear evidence that interest rates undergo persistent changes (as well as relative prices and the exchange rate). Further, it is found that the forecast errors about the interest rate differential have a large and highly statistically significant impact on the exchange rate, even independent of the level and change in the interest rates.  A polynomially cointegrating equilibrium is found between the real exchange rate, interest rate differential, and forecast error about the interest rate differential. The forecast error in particular appears to be primarily responsible for the I(2) stochastic trend, which contributes to the additional persistence of the exchange rate. The interpretation offered is that market participants extrapolate the unexpected changes in the interest rate differential provoking a positive feedback dynamic for the exchange rate, which generates the commonly observed long swings behavior. This analysis will be expanded to two additional samples of exchange rates against the US dollar, with the Japanese yen and Swiss franc.