Friday, 23 July 2010

Euro redivivus...

or dead cat bounce? The Euro has surged since touching a recent low of below 1.20 to the dollar. After relentless news headlines hammering the common currency, and all the pundits claiming that parity was next, the market decided to turn a corner. Apparently, the upcoming double-dip in the US is even worse than all the "EU can't compete" sneers of our Anglo-Saxon friends. But make no mistake - purchasing power parity is still a long way off, and probably closer to 1.10 or so. That's true if you look at the Big Mac Index or more sophisticated measures, which the Economist just updated today. OANDA updates the Big Mac Index every day [and cites the exchange rate the other way around, i.e. you get 0.78€ per $]. Introduced by the Economist, it simply uses the ratio of Big Mac prices in different countries as an exchange rate forecast. It actually does pretty well, over relatively long time horizons. Elsewhere, Orley Ashenfelter and co-authors have used Big Mac prices to calculate ppp-adjusted wages. So, what does this mean for the exchange rate? In the short term, there is no way to tell. It's darn easy to tell really pessimistic stories about the US economic outlook (making monetary easing more likely than tightening), or do the same for Euro (another failed bond auction, anyone?). Over the medium term, I expect those Big Macs to do well at forecasting.

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