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Forward-Looking Policy Rules and Currency Premia

Published online by Cambridge University Press:  09 September 2022

Ilias Filippou Open the ORCID record for Ilias Filippou [Opens in a new window]  and
Mark P. Taylor Open the ORCID record for Mark P. Taylor [Opens in a new window]
Ilias Filippou
Affiliation:
Washington University in St. Louis Olin School of Business IliasFilippou@wustl.edu
Mark P. Taylor*
Affiliation:
Washington University in St. Louis Olin School of Business, Brookings Institution, and Centre for Economic Policy Research
*
Mark.P.Taylor@wustl.edu (corresponding author)
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Abstract

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We evaluate the cross-sectional predictive ability of a forward-looking monetary policy reaction function, or Taylor rule, in both statistical and economic terms. We find that investors require a premium for holding currency portfolios with high implied interest rates while currency portfolios with low implied rates offer negative currency excess returns. Our forward-looking Taylor rule signals are orthogonal to current nominal interest rates and disconnected from carry trade portfolios and other currency investment strategies. The profitability of the Taylor rule portfolio spread is mainly driven by inflation forecasts rather than the output gap and is robust to data snooping and a wide range of robustness checks.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 58 , Issue 1 , February 2023 , pp. 449 - 483
Copyright
© The Author(s), 2022. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We are grateful to an anonymous referee and Hendrik Bessembinder (the editor) for constructive and helpful comments on an earlier version of this article. All remaining errors are the responsibility of the authors.

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