Taylor rules and the euro

This paper uses real-time data to show that the variables which normally enter central banks ’ Taylor rules for interest-rate-setting, can provide evidence of out-of-sample predictability for the U.S. Dollar/Euro exchange rate from the inception of the Euro in 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 U.S. and the Euro Area, do not incorporate interest rate smoothing, and do not include the real exchange rate in the forecasting regression. The evidence of predictability is found with both one-quarter-ahead and longer horizon forecasts