The Influence of Policy Uncertainty on Exchange Rate Forecasting

Abstract

Using the economic policy uncertainty (EPU) index of Baker et al. (2016), we examine the influence of EPU on the characteristics of USD/JPY exchange rate forecasts. Our sample period, which spans two decades, incorporates a range of economic and political conditions for the US and Japan. Consistent with higher EPU engendering a more complex information environment, our results clearly demonstrate that analyst forecast errors, and forecast dispersion, increase with EPU. US monetary policy uncertainty and Japanese trade policy uncertainty are particularly important in generating forecast dispersion. The empirical findings are consistent across forecast horizons ranging from 1-month to 1-year. This has important implications for market participants who use exchange rate forecasts when making business and investment decisions.

Keywords: Economic Policy Uncertainty, EPU, Analyst Forecasts, Foreign Exchange Market

JEL Classification: G10, G14, G15, G17