Why I don’t forecast exchange rates

Why I don’t forecast exchange rates

As your friendly neighborhood economist, I get many questions on currencies. Where do I see the euro in a week or month? When would be a good time to exit the lira? As much as I believe in the age-old saying “the customer is king,” I refuse to answer such queries.

Not because the dismal science does not have much to say about currencies. On the contrary, economic fundamentals usually do a pretty good job in predicting the direction of exchange rates, if not the exact amount of their movement, in the long run. Economists have developed many models, some of them quite complex, which do that. The problem is that they can sometimes reach different conclusions.

One of the simplest and most well-known is the Economist’s “Big Mac index,” which tries to assess the relative strength of currencies based on the prices of McDonald’s Big Macs across countries. According to the latest version published on Jan. 22, the lira was undervalued 17.2 percent against the dollar. It has depreciated 15 percent further since then.

On the other hand, according to another well-known measure, the lira is still overvalued. The Peterson Institute for International Economics published the latest of its semi-annual estimates of fundamental equilibrium exchange rates (FEERs) on May 29. A FEER is an exchange rate that would generate a current account balance matching sustainable capital flows. This framework finds that a real exchange rate depreciation of nearly 9 percent is needed for Turkey. Interestingly, the dollar turns out to be overvalued against all currencies except the lira.

But these models are not very useful in practice. Even if they predict the direction of a currency, or even the degree of misalignment, correctly, the exchange rate will never get there in a straight line. Besides, currencies are usually decided by unexpected factors, or “unknown unknowns,” in the short run. That’s why you don’t see many economists who have made their fortunes from betting on exchange rates.

To illustrate, even though I was sure that the lira would significantly depreciate against the dollar in 2015, on the dollar’s strength as much as the lira’s weakness, the speed of adjustment was much faster than what I had anticipated. I just could not foresee President Recep Tayyip Erdoğan’s tirades against the Central Bank.
It is no wonder that Refet Gürkaynak of Bilkent University admitted back in February that he could not forecast the lira-dollar exchange rate because he could not predict what Erdoğan would say.

How about all those people who get rich from trading currencies, whose stories regularly feature in newspapers? This is one of favorite economic fallacies, what I call “Llewyn Davis bias” after my favorite Coen Brothers movie: For every successful trader, or Bob Dylan, there are hundreds who have sunk their savings, or folk singers who could not make it – whose stories you don’t get to hear. I know a guy who lost an exorbitant sum betting on the lira, and is now writing very successful, and equally crappy, novels to pay off his debts.

So even if you don’t care about junior’s university fund, please do the literature world a favor and do not bet on currencies. If you really need the dough, try your luck in Vegas. You’ll at least have more fun – and success, at least for a while, if you learn to count cards.