Menzie Chinn submits: As Europe teeters on the edge of recession [0], and the United States remains mired in slow growth, expectations of what interest rates, and hence exchange rates, are shifting. Here's a familiar depiction of where policy rates in the US and the euro area have been, and where they are predicted to go. Figure 1: Policy rates and predictions. Source: Deutsche Bundesbank, Global Economic Perspectives July 21, 2008. As long the euro area rate is projected to be above, and rising relative to, the US interest rate, the euro should remain strong against the dollar. These expectations are popularly thought to be a function of output and inflation gaps. This suggests that output and inflation gaps usefully be thought of as fundamentals for exchange rates. In other words, Taylor rule fundamentals can be used as empirical determinants of exchange rates. [1]Complete Story »