Purchasing Power Parity (PPP) is generally considered a tool for the long run. For reasons linked to carry trade strategies, monetary policy, and risk aversion, departures from fair-value can last a while. Divergence away from the PPP can be a very long lasting phenomenon as the USD/JPY experience highlights.
The following chart compares the EUR/USD to the level of over/undervaluation suggested by the Big Mac Index. According to this metric, the EUR/USD is overvalued by 10% today (red bars below). This chart shows that between 2008 and today the purchasing power implied EUR/USD has moved much more sharply than the market value of the pair (from 40% overvalued to less than 10% today). If it's not linked to movements in the pair it must be attributable to relative prices adjustments.
Below I check the relative trend in inflation observed on both sides of the Atlantic. According to PPP, if inflation is higher in the U.S. than it is in Europe, the dollar has to depreciate against the euro. Yet, as can be seen below, the cumulative spread between U.S. and eurozone inflation since 2008 is only 5%. It cannot explain the relative adjustment in Big Mac prices.
Interestingly enough, the decline in the EUR/USD "overvaluation" can be explained by the cumulative difference (30%) in core inflation between the U.S. and the eurozone since the Great Recession. This seems odd though, since if we strip the "Big Mac" out of food and oil (transportation cost), there is not much left!
Setting aside the unsolved question of the fall in the Big-Mac-implied overvaluation of the euro, we notice a very close relationship between the U.S.-to-Europe CPI ratio and the EUR/USD. A higher ratio leads to a higher EUR/USD. This would suggest that PPP works in the short run, too! A glimpse at the chart below would even suggest that the pair has further room to edge up.
Of course inflation can just synthesize several factors such as growth (wage implied inflation), commodity price trends and even monetary policy if the reaction function of the central bank ascribes a high weigh to the CPI. But in any case, a model based on the spread between 2-year sovereign yield, the VIX and the CPI ratio explains 73% of the total variance of the EUR/USD since 2008.
Drawing upon my forecasts for U.S. and UEM inflation in 2014 and 2015, the EUR/USD may have room to appreciate further. The chart above suggests a EUR/USD at 1.45 (and I am not the most pessimistic about deflation in Europe)!
The conclusion from my model is not the same. The reason is to be found in my relative yield forecast since the ECB will keep a status quo while the Fed will continue to tighten. The chart below highlights the diverging forces at play: higher CPI ratio (red line) and lower 2-year sovereign yield spread (blue line).
What about the medium run? The relative levels of the inflation swap curve highlight what is at stake for the euro. We have to be cautious here, as what matters for the EUR/USD forecast is not so much the inflation spread forward but the trend in the ratio of U.S. and eurozone CPI indexes.
If we assume (wrongly) that the 1-to-10 year inflation swap strip reflects the inflation levels in 1-2-to-10 years respectively, then the ratio of CPI will actually fall within two years and the EUR/USD could go back to 1.15.
Bottom line: The recent strengthening of the EUR/USD can be attributable to at least two factors: the perception that the eurozone would not be harmed by a systemic risk (the "whatever it takes" effect) and the ongoing cyclical recovery, which is lifting the European unit through PMI spreads.
Yet, the most important driver for the EUR/USD is the internal disequilibrium between saving and investment. As is well known, the difference between investment and saving is equal to the current account. The sharp increase in the eurozone current account balance suggests that the euro is in short supply and, as a result, stronger (ex. Japan in the 2000s). The reason I insist on this (current account = saving-investment) is that, as a paradox, a strong recovery in Europe led by stronger capital expenditures would reduce the current account and may therefore weaken the EUR/USD.
If my analysis is correct, the same force is at play regarding the disinflation risk in Europe. As PPP seems to be working in the short run, a widening of the ratio of price levels in the U.S. and eurozone drives the pair on the upside. It is partially offset by relative monetary policy stances. But reflation in Europe is clearly a condition for a weaker EUR/USD.
Interestingly enough, and contrary to the Japanese case, the fall in the currency would not be "used" by the central bank to reflate the economy and spur a "demand switch" (more exports, less consumption). It is the combination of a slow process of reflation and investment spending that will bring the EUR/USD lower.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.