Taylor Rule and FX Returns
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Forward-Looking Policy Rules and Currency Premia
Ilias Filippou; Mark P. Taylor
- Washington University in St. Louis
- ?Washington University in St. Louis - John M. Olin Business School
- Centre for Economic Policy Research
- Brookings Institution
- ?Centre for Economic Policy Research (CEPR)
Strategy in a nutshell
The strategy targets USD currency pairs across 15 countries, including Australia, Canada, Japan, and the Eurozone. A Taylor rule signal is computed using inflation forecasts, inflation targets, output gaps, and the actual interest rate, with constants β = 1.5, γ = 0.5, and λ. The Hodrick-Prescott filter is used to estimate output gaps. Currencies are ranked into quintiles based on the previous month’s policy signal, with long positions in the top quintile and short positions in the bottom quintile. The portfolio is rebalanced monthly.
Economic rationale
The strategy exploits deviations of inflation from central bank targets, which influence interest rate adjustments via the Taylor rule. Higher projected rates attract capital, leading to currency appreciation. By forecasting relative interest rate differentials, the strategy predicts currency movements independently of traditional carry, momentum, or value strategies. Empirical evidence shows the strategy remains significant after transaction costs, highlighting the predictive power of Taylor rule-based signals in FX markets.