The persistence of the ‘peso problem’ when policy is noisy

The ‘peso problem’, the market's belief that a discrete event may occur, has frequently been blamed for the persistence of on-average mistaken forecasts of macroeconomic variables. This paper demonstrates how beliefs that a policy process may have switched can induce apparent ex post biased forecasts of exchange rates even after the switch has occurred . Furthermore, during this ‘peso problem’ period, exchange rates may appear to contain a speculative bubble component since they will systematically deviate from the levels implied by observing fundamentals ex post; and the conditional variance of exchange rates will exceed the variance implied by observing fundamentals.