Are outcomes driving expectations or the other way around? An I(2) CVAR analysis of interest rate expectations in the dollar/pound market

This paper uses consensus forecasts to address empirical puzzles in international macro using the Cointegrated VAR model. The data, consisting of three-month Libor rates, their three-month ahead forecasts, prices and exchange rates for the US and UK, were all found to be near I(2) consistent with imperfect knowledge expectations. The I(2) analysis showed that over the medium run the nominal exchange rate has moved away from equilibrium values with interest rates following suit, whereas over the long run the nominal exchange rate was adjusting while the interest rate forecasts pushed the system away from steady state. Evidence of self-reinforcing feedback mechanisms in the system signals the importance of speculative bubbles for the determination of the exchange rate and the interest rates.