Based on the New York Board of Trade’s US Dollar Index (USDX; DX for short), it is almost universally believed that the value of the USD has recently declined to all time new lows (below the previous low lof about 79 reached in 1992).

The DX is the most widely used index as a measure of the exchange rate value of the US Dollar (USD). This index represents the value of the US Dollar against a basket of six major currencies: Euro (57.6%), Japanese Yen (13.6%), UK Pound (11.9%), Canadian Dollar ( 9.1%), Swedish Krona (4.2%), and Swiss Franc (3.6%). Although it has considerable usefulness for visualizing the general direction of the USD’s exchange rates and hence the strength or weakness of the USD at any particular time, this index is of little value, and indeed grossly misleading, when used to make historical comparisons such as the strength or weakness of the USD between the current and different periods of time in the past.

Many economists and most Central Banks prefer to gauge the strength or weakness of currencies in terms of deviations from normal equilibrium levels as measured by a variety of methods among which the Purchasing Power Parity (PPP) is the most widely applied. The theory is that at PPP, different currencies should purchase a given basket of goods at the same price in their home countries. Normally, movements in exchange rates tend to equalize the purchasing power of different currencies. Thus, PPP is often used to compare standards of living between countries, rather than per-capita GDP calculated at market exchange rates. On many occasions, significant, albeit temporary, differences between PPP and market exchange rates can be observed.

In view of the persistent and widely advertised weakness of the USD since 2002, it is considered particularly instructive at this time to place this weakness in a more objective perspective, particularly against the Euro since this currency has the largest weight in the DX and the US still imports more from Europe than from China.

From the following charts it is evident that, although the market exchange rates of the USD against the Euro have surpassed the previous peaks of 1980 and 1992 (Chart 1), in terms of PPP the recent market exchange rate of 1.5375 is still  lower than that recorded at those peaks (Chart 2). Indeed, to reach the 32-35% value above PPP as in 1980 and 1992, the rate would have to rise to 1.58-1.62. 

Conclusion: The weakness of the USD, when deduced solely from the USDX and recent USD/Euro market exchange rates, has been grossly overstated. When measured against the PPP, the extent of USD depreciation thus far has been significantly less than observed in earlier business cycles. Considerable headroom still remains for the Euro to appreciate further before past overvaluation extremes are reached.

Useful links:

http://en.wikipedia.org/wiki/Purchasing_power_parity

http://www.alaron.com/uploadedFiles/alaron/client_services/exchange_resources/NYBOT/USDXvehicle.pdf