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 Euro against the USD have surpassed the previous peaks of 1980 and 1992 (Chart 1), in terms of PPP the recent market rate high of 1.50 is still nearly half lower than recorded at those peaks (Chart 2). Indeed, to reach the 50% value above PPP as in 1980 and 1992, the Euro market exchange rate would have to rise to 1.78 from the current 1.487.

Conclusion: The weakness of the USD deduced solely from the USDX and recent market exchange rates of the Euro against the USD, has been grossly exaggerated. In spite of the record current account deficits run by the U.S., the weakness of the USD has been significantly less thus far than observed in earlier business cycles. A corollary to this conclusion is that considerable headroom remains fo the Euro to appreciate further agaist the USD.

Useful links:

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

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