With market expectations firming around a likely interest rate hike by the United States Federal Reserve next month, it has also been commonly assumed that this will imply a rise in the US dollar. After all, higher US interest rates should make investing in the United States more attractive, which should attract investment capital and push up the greenback. Somewhat surprisingly, however, history suggests this is not always the case.
New analysis suggests the US dollar is undervalued on a purchasing power parity basis against 15 of the 18 major countries/currencies. The purchasing power parity (PPP) theory 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.