Exchange Rates and Fundamentals : Is there a Role for Nonlinearities in Real Time?

We examine the out-of-sample predictive power of real time linear monetary models with possible nonlinear adjustment in forecast errors for the GBP/USD exchange rates. Real time revisions of U.K. and U.S. monetary aggregates and output are significant; therefore the use of final data on fundamentals in forecasting exchange rates may yield misleading inferences. By studying recursive out-ofsample forecast errors we claim that in several instances, real time fundamental equilibrium values of exchange rates may be determined in a linear fashion, whereas the adjustment towards fundamentals driven equilibrium values may take a discrete or smooth nonlinear form. Revisions in fundamentals, particularly in the US and UK monetary aggregates and real output, seem to matter mainly for short term forecastability of exchange rates. We find short term forecastability in the form of discrete nonlinear adjustment in some real time vintages. We also document long term forecastability in the form of a smooth nonlinear adjustment towards fundamentals determined equilibrium values of exchange rates.