Over the past few months, a growing number of market analysts have claimed that the strong dollar is poised for a reversal because it is overvalued.
Their claim is based on an economic theory called purchasing power parity (PPP). PPP is based on the “Law of One Price”: the cost of a good or basket of goods should be the same in all countries, assuming trade is free of transport costs and trade barriers . Otherwise, the country with the most expensive goods is thought to have an overvalued currency, which weakens over time as the undervalued currencies strengthen (towards a “cost equilibrium” rate).
The International Monetary Fund, the OECD, the World Bank and the United Nations have all created complex measures of PPP. The Big Mac Index was created by The Economist and based on the cost of a single item – a Big Mac from McDonald’s. Here’s the logic – a Big Mac that costs $5.00 in New York should cost 100 pesos in Mexico City, since the current exchange rate is around 20 MXN/$1. However, a Big Mac only costs 50 pesos in Mexico City. For this reason, the index indicates that the peso is undervalued by 50% (see table below). The Big Mac Index has had a surprisingly accurate history of predicting currency movements against more complex PPPs.
Here are the current Big Mac PPP valuations for fifteen currencies against the US dollar:
With the exception of the Swiss franc, all listed foreign currencies are PPP undervalued against the USD. By definition, the dollar is therefore overvalued in PPP terms against these currencies, which is why some analysts are taking note.
It is important to mention, however, that the PPP theory has real shortcomings – transport is not free, and the quality and preference for goods differs from country to country. But a bigger problem makes PPP virtually useless for forecasting currencies in the short to medium term: currencies can stay overvalued or undervalued for long periods of time. The Japanese yen has been undervalued against the dollar by at least 10% for the past five years, and the Swiss franc has been overvalued against the dollar by more than 15% for decades! As such, most FX professionals, myself included, view PPP as a minor data point when forecasting forex rates.