The predictability of the exchange rate when combining machine learning and fundamental models

In 1983, Meese and Rogoff showed that traditional economic models developed since the 1970s do not perform better than the random walk in predicting out-of-sample exchange rates when using data obtained after the beginning of the floating rate system. Subsequently, whether traditional economical models can ever outperform the random walk in forecasting out-of-sample exchange rates has received scholarly attention. Recently, a combination of fundamental models with machine learning methodologies was found to outcompete the predictability of random walk (Amat et al. 2018). This paper focuses on combining modern machine learning methodologies with traditional economic models and examines whether such combinations can outperform the prediction performance of random walk without drift. More specifically, this paper applies the random forest, support vector machine, and neural network models to four fundamental theories (uncovered interest rate parity, purchase power parity, the monetary model, and the Taylor rule models). We performed a thorough robustness check using six government bonds with different maturities and four price indexes, which demonstrated the superior performance of fundamental models combined with modern machine learning in predicting future exchange rates in comparison with the results of random walk. These results were examined using a root mean squared error (RMSE) and a Diebold-Mariano (DM) test. The main findings are as follows. First, when comparing the performance of fundamental models combined with machine learning with the performance of random walk, the RMSE results show that the fundamental models with machine learning outperform the random walk. In the DM test, the results are mixed as most of the results show significantly different predictive accuracies compared with the random walk. Second, when comparing the performance of fundamental models combined with machine learning, the models using the producer price index (PPI) consistently show good predictability. Meanwhile, the consumer price index (CPI) appears to be comparatively poor in predicting exchange rate, based on its poor results in the RMSE test and the DM test.