Predicting Exchange Rates Is Hard. Could Dusting Off an Old Technique Help?
Skip to content
Finance & Accounting Economics Jan 2, 2020

Predicting Exchange Rates Is Hard. Could Dusting Off an Old Technique Help?

Investors take note: the “real exchange rate” may be a more accurate long-term forecaster than economists thought.

Economists have uncovered a better way to predict fluctuations in exchange rates.

Yevgenia Nayberg

Based on the research of

Martin Eichenbaum

Benjamin Johannsen

Sergio Rebelo

When foreign exchange rates rise or fall, investors should pay close attention. After all, those changes have a large impact on the returns to foreign investments.

While $100 may buy you, say, a 10,000-yen stake in a Japanese company, the value of your investment in U.S. dollars will fluctuate according to the exchange rate between the yen and the dollar, which is constantly changing. So, if exchange-rate fluctuations could be predicted, investors could improve the timing of their foreign investments and earn higher returns.

Despite decades of research, economists have yet to identify a reliable way to forecast exchange rates. The best method, called a “random walk,” involves using today’s exchange rate to forecast future exchange rates. “It is the best method, but it is lousy,” says Sergio Rebelo, a professor of finance at Kellogg.

Now, Rebelo and his colleagues Martin Eichenbaum of Northwestern University and Benjamin K. Johannsen of the Federal Reserve have come up with something better. They found that the nominal exchange rate between two currencies—for example, the number of Japanese yen equivalent to one U.S. dollar—varies predictably according to a standard economic indicator called the “real exchange rate.” This indicator compares the price of goods in two different countries. For example, if one dollar equals 100 yen, and an orange costs $1 in the U.S. and 100 yen in Japan, the “real exchange rate” between the two countries is 1, because the price of an orange in dollars is the same in the two countries.

Rebelo and his colleagues found that movements in the real exchange rate lead to predictable changes in the nominal exchange rate. The catch? This prediction method doesn’t work in the short term. “You can only forecast the nominal exchange rate three to ten years out, not sooner.” Rebelo says.

While this medium- to long-term predictability won’t change the way short-term-currency speculators do business, it can have big effects on the timing of foreign direct investments. “When you invest in another country, you’re going to be there for 20 or 30 years, if not longer,” Rebelo says. “Our method beats the random walk by a wide margin at medium and long horizons—and these are the horizons that are important for businesses.”

What Determines the Real Exchange Rate?

The real exchange rate can be computed with some back-of-a-napkin math: if you take the ratio of prices of the same good in two countries and multiply by the nominal exchange rate, you get the real exchange rate.

The idea that the real exchange rate predicts future currency fluctuations is not new. Two decades ago, researchers noticed a predictive relationship, but subsequent research found it to be mysteriously unreliable. In some countries, the real exchange rate could predict the nominal exchange rate three to ten years out, but in other countries, the two values showed no relation at all. “So, researchers concluded that the results were not robust and abandoned the idea,” Rebelo says.

Today, with a few more decades of data to draw from, the authors hoped to get a deeper understanding of the predictive power of the real exchange rate.

Getting the data on nominal exchange rates and prices was straightforward—Rebelo and his collaborators obtained their data from the International Monetary Fund’s International Financial Statistics database, collecting nominal exchange rates and prices from 23 countries between 1973 and 2008.

Monetary Policy and Exchange-Rate Predictability

Thanks to their wealth of historical data, Rebelo and his collaborators discovered two reasons for the lack of robustness in predictive ability.

First, they found, the real exchange rate only predicts the nominal rate in currencies of countries with floating exchange rates, meaning the price of the country’s currency in dollars (for example, one dollar to 100 yen) is allowed to fluctuate (or “float”) according to supply and demand. Under this type of regime, when Americans demand more yen, for example, the yen will cost more in dollars and the Japanese government won’t intervene to prevent this appreciation from occurring.

Second, the central banks of the two countries must follow an inflation-targeting policy. That is, the country must be willing to adjust interest rates to keep the inflation rate around a target value, like two percent per year.

The real exchange rate is what economists call a “stationary series.” “When it’s high, it tends to come down, and when it’s low, it tends to go up,” Rebelo explains. However, these corrections generally take three to ten years to occur, which is why the real exchange rate is not useful for predicting the nominal exchange rate in the short term. “But it works beautifully for long-run forecasts,” Rebelo says.

This stationary nature of the real exchange rate is also key to its predictive power. In countries with inflation-targeting policies, the way that the real exchange rate reverts towards the mean is through changes in the nominal exchange rate. (For instance, if goods cost significantly more in Japan than in the U.S., the yen–dollar nominal exchange rate will gradually adjust until the real exchange rate hits its “normal” level.) As a result, the current real exchange rate predicts the future nominal exchange rate.

“The real exchange rate is an important predictor of how much value the deal will create.”

Most advanced economies began shifting to floating exchange rates after the U.S. detached the dollar’s value from gold in 1973. In recent decades, inflation targeting has become quite common as well: Canada, Germany, and the UK adopted it in the 1990s; the United States only officially began targeting inflation in 2012 but has done so unofficially since 1986.

This decades-long trend in nations’ monetary policy gave Rebelo and his coauthors “before and after” scenarios to further test whether real exchange rates could predict nominal exchange rates.

For example, in 1999 Brazil adopted both an inflation-targeting monetary policy and a floating exchange rate for its currency. Rebelo’s data show that between 1982 and 1999, there is no correlation between Brazil’s current real exchange rate and future values of the nominal exchange rate.

But after 1999, a pattern emerged: high or low values of the real exchange rate for Brazil were followed by corrections in the value of Brazil’s currency. In 2011, the real exchange rate between Brazil and the U.S. was the highest in 30 years, but by 2016 it had corrected back downwards to average levels. And sure enough, the nominal exchange rate depreciated by roughly 60 percent between 2011 and 2016.

Why Investors Should Pay Attention to Real Exchange Rates

Rebelo says his findings are of interest to any company making foreign investments, because “the number-one driver of success or failure of these investments is timing, as far as the exchange rate is concerned.”

“Investments in foreign currency—whether in land, equipment, or shares—made at high real exchange rates are likely to see their dollar value decline over time because of the depreciation of the foreign currency,” he explains. By the same logic, making a foreign investment when the real exchange rate is unusually low “puts the wind at your back, because the dollar value of the assets will tend to improve over time.”

However, Rebelo reminds investors that this rule of thumb only applies to countries with floating exchange rates and an inflation-targeting monetary policy. While that covers most developed countries, it excludes countries like China, which do not have floating exchange rates.

Rebelo believes that examining real exchange rates should become standard in evaluating foreign investments. “Companies spend a lot of time looking at many aspects of foreign deals—but often they don’t look at the real exchange rate,” he says. This omission is unwise, he warns, since “the real exchange rate is an important predictor of how much value the deal will create.”

Featured Faculty

Charles Moskos Professor of Economics, Weinberg College of Arts & Sciences; Co-Director, Center of International Macroeconomics (CIM); Professor of Executive MBA (Courtesy)

MUFG Bank Distinguished Professor of International Finance; Professor of Finance

About the Writer
John Pavlus is a writer and filmmaker focusing on science, technology, and design topics. He lives in Portland, Oregon.
About the Research
Eichenbaum, Martin, Benjamin K. Johannsen, and Sergio Rebelo. 2019. "Monetary Policy and the Predictability of Nominal Exchange Rates." Working paper.
Most Popular This Week
  1. How Much Do Boycotts Affect a Company’s Bottom Line?
    There’s often an opposing camp pushing for a “buycott” to support the company. New research shows which group has more sway.
    grocery store aisle where two groups of people protest. One group is boycotting, while the other is buycotting
  2. 5 Takeaways on the State of ESG Investing
    ESG investing is hot. But what does it actually deliver for society and for shareholders?
    watering can pouring over windmills
  3. Could Bringing Your "Whole Self" to Work Curb Unethical Behavior?
    Organizations would be wise to help employees avoid compartmentalizing their personal and professional identities.
    A star employee brings her whole self to work.
  4. When Do Open Borders Make Economic Sense?
    A new study provides a window into the logic behind various immigration policies.
    How immigration affects the economy depends on taxation and worker skills.
  5. Which Form of Government Is Best?
    Democracies may not outlast dictatorships, but they adapt better.
    Is democracy the best form of government?
  6. How Has Marketing Changed over the Past Half-Century?
    Phil Kotler’s groundbreaking textbook came out 55 years ago. Sixteen editions later, he and coauthor Alexander Chernev discuss how big data, social media, and purpose-driven branding are moving the field forward.
    people in 1967 and 2022 react to advertising
  7. What Happens to Worker Productivity after a Minimum Wage Increase?
    A pay raise boosts productivity for some—but the impact on the bottom line is more complicated.
    employees unload pallets from a truck using hand carts
  8. Why Do Some People Succeed after Failing, While Others Continue to Flounder?
    A new study dispels some of the mystery behind success after failure.
    Scientists build a staircase from paper
  9. What Went Wrong at AIG?
    Unpacking the insurance giant's collapse during the 2008 financial crisis.
    What went wrong during the AIG financial crisis?
  10. Why Well-Meaning NGOs Sometimes Do More Harm than Good
    Studies of aid groups in Ghana and Uganda show why it’s so important to coordinate with local governments and institutions.
    To succeed, foreign aid and health programs need buy-in and coordination with local partners.
  11. 3 Tips for Reinventing Your Career After a Layoff
    It’s crucial to reassess what you want to be doing instead of jumping at the first opportunity.
    woman standing confidently
  12. How Are Black–White Biracial People Perceived in Terms of Race?
    Understanding the answer—and why black and white Americans may percieve biracial people differently—is increasingly important in a multiracial society.
    How are biracial people perceived in terms of race
  13. Podcast: Does Your Life Reflect What You Value?
    On this episode of The Insightful Leader, a former CEO explains how to organize your life around what really matters—instead of trying to do it all.
  14. Immigrants to the U.S. Create More Jobs than They Take
    A new study finds that immigrants are far more likely to found companies—both large and small—than native-born Americans.
    Immigrant CEO welcomes new hires
  15. In a World of Widespread Video Sharing, What’s Real and What’s Not?
    A discussion with a video-authentication expert on what it takes to unearth “deepfakes.”
    A detective pulls back his computer screen to reveal code behind the video image.
  16. College Campuses Are Becoming More Diverse. But How Much Do Students from Different Backgrounds Actually Interact?
    Increasing diversity has been a key goal, “but far less attention is paid to what happens after we get people in the door.”
    College quad with students walking away from the center
More in Finance & Accounting