Exchange Rates and Fundamentals: Is there a Role for Nonlinearities in Real Time?

We examine out of sample predictive power of real time monetary models with nonlinear adjustment in forecast errors for the Pound Sterling/US Dollar exchange rates. Real time revisions of U.K. and U.S. monetary aggregates and output are significant. By studying recursive out of sample forecast errors we claim that in several instances, real time fundamental equilibrium values of exchange rates may be determined in a linear fashion, whereas adjustment towards the fundamentals driven equilibrium values may take a discrete or smooth nonlinear form. Revisions in fundamentals, particularly in the US and UK monetary aggregates and real output, seem to matter mainly for short term forecastability of exchange rates. We find in some real time vintages short term forecastability in the form of discrete nonlinear adjustment. We also document long term forecastability in the form of smooth nonlinear adjustment towards fundamentals determined equilibrium value of exchange rates