Forward-Looking Policy Rules and Currency Premia

Ilias Filippou and Mark P. Taylor

We evaluate the cross-sectional predictive ability of forward-looking monetary policy reaction functions, or Taylor rules, in both statistical and economic terms. We find that investors require a premium for holding currency portfolios with high implied interest rates while currency portfolios with low implied rates offer negative excess returns. Our forward-looking Taylor rule signals are orthogonal to current nominal interest rates and disconnected from carry trade and other currency investment strategies. The profitability of the Taylor rule strategy is mainly driven by inflation forecasts rather than the output gap and is robust to data snooping and a battery of robustness checks.