USD Still Undervalued On a Purchasing Power Parity BasisDecember 09, 2013
The purchasing power parity (PPP) theory basically states that the exchange rate between two countries should adjust so that a basket of goods in Country X costs the same as it does in Country Y when priced in the same currency. It is a useful theory in understanding the relative strength of a currency, especially for a reserve currency such as the USD. It is important to keep in mind that over/under valuation based on PPP can remain in place for years and that this is not at all a timing tool.
The USD is currently undervalued against 15 of the 18 countries that we track it against on a PPP basis. We show this visually by building a diffusion index (every time the USD is undervalued it registers a +1, if it is overvalued it registers a -1).
Below are some individual PPP charts of the USD vs other major currencies. While the USD may still be undervalued, it has generally strengthened on a PPP basis over the past two years.