Can policy shifts explain the forward discount puzzle?

In this paper we argue that major shifts in monetary policy regimes can help explain the forward discount puzzle. We hypothesize that shifts by central banks from destabilizing regimes—when the Taylor principle is violated—to stabilizing regimes—when a central bank follows a Taylor-type rule—can cause violations of uncovered interest rate parity. Following the shift is an adjustment period when the forward discount puzzle clearly appears, as forecasters gradually update their expectations, eventually restoring parity. We test this hypothesis using four major currencies: the Canadian dollar, German mark, and the British pound, against the US dollar. Results indicate that the evidence for the forward discount puzzle becomes significantly weaker after allowing for an adjustment period of as little as 18 months. These results are robust to different specifications, such as the use of different maturities or base currencies, and also hold for the New Zealand dollar and the Swedish krona, two smaller, but independent currencies.