MNI: Financial Variables Better For FX Forecasts -BCB Analyst

Central bankers should be better able to forecast short-term exchange rate fluctuations by incorporating financial market variables into traditional models focused only on economic indicators, a Central Bank of Brazil analyst who has just published research on the issue told MNI.

Market indicators tend to be more timely and forward-looking than economic ones, the BCB’s Jaqueline Marins said in an interview.

"Option prices, unlike economic variables, are available daily and promptly obtained, which is a clear advantage if the intention is forecasting with greater frequency. It is worthy of research, especially for short-run forecasting, and it remains on our agenda for future research," she said, emphasizing the results of her work reflect only her own views as a researcher, and do not necessarily reflect the views of the central bank.

Published in January, the new study is an extension of another paper from 2017, co-authored by Marins and Wagner Gaglianone, a deputy advisor at BCB. In the first version, the researchers had used financial variables to forecast FX in Brazil and compared them with other models. (See MNI INTERVIEW: BCB Likely To Keep Cuts Guidance -Schwartsman)

"The results obtained in this paper do not discourage the use of economic fundamentals in predicting FX rates. Nevertheless, it sheds some light on the need to include financial variables, namely FX option data, in the prediction models, as these data are totally forward-looking, instead of being based on historical economic variables," highlighted the new paper.

FX KEY FOR SCENARIO ANALYSIS

The new version included another 13 emerging economies: India, Mexico, Russia, Chile, Singapore, South Africa, Turkey, Colombia, Malaysia, Indonesia, Israel, Philippines, and Thailand. (See MNI POLICY: G20 CenBanks Worried By Optimistic Markets)

"In the initial version of the article, the pandemic period had not been fully included in the sample. However, the results proved robust in the current version where the pandemic was considered," the author told MNI.

The Central Bank of Brazil uses exchange rate forecasts in its scenario analyses and risk assessments, with the starting point taken as the average real-dollar exchange rate over the 10 business days ending on the last day of the week before the meeting. This averaging period was extended from five days as of the Bank’s November meeting, in order to smooth out volatility.

"It is considered that this will achieve a better balance between using more recent information and lower sensitivity to high-frequency variations. However, this change does not prevent the Committee from analyzing, in its decision-making process, scenarios using other criteria," the central bank said it its September quarterly inflation report when announcing the change.

The central bank’s current forecasts assume the real will trade in line with changes in its purchasing power adjusted for inflation, and that interest rates evolve as predicted in the Focus market survey. But the real has outperformed in purchasing power terms in recent times, appreciating by about 5% against the dollar over the past year in nominal terms despite higher Brazilian inflation and trading in a relatively narrow band by historical standards.