Despite record exchange rates: this is why things have gotten so quiet on strong Swiss franc

Pizza suddenly costs so much when it almost doubles

If you go to Italy or France in the near future, you will understand why: pizza, like French breakfast, suddenly exceeded 10 euros. The exchange rate advantage is consumed by high inflation. Due to the devaluation of the euro, products in the currency union did not become much cheaper.

This is no coincidence and not just a current phenomenon. This is exactly what the exchange rate theories in textbooks predict. One of them is the so-called purchasing power parity (PPP). In its strictest form, also called absolute PPP, this specifies that in perfect markets without shipping costs, the same basket of goods costs the same in two countries after conversion to the same currency. The exchange rate is nothing but the ratio of local prices.

If the same products are 100 euros in Germany and 150 francs in Switzerland, the exchange rate per euro should be 1.50 francs. Then there is absolute PPP.

Same price for the same goods

If the exchange rate falls below purchasing parity, it is theoretically worth exporting German products to Switzerland and selling them more expensive there. This arbitrage profit would be possible until the additional demand for the euro raises the euro-franc rate to 1.50 francs per euro.

The idea of ​​absolute purchasing power parity also lags behind the Big Mac Index. The weekly The Economist researches the prices of McDonald’s Big Mac, which has been a standard item since 1986. Under absolute purchasing power parity, this should cost the same everywhere when converted to dollars.

But it doesn’t. The Big Mac costs CHF 6.70 in Switzerland and $5.36 in the US, according to The Economist. The exchange rate is not 1.25, but 0.90 francs per dollar. From this it can be concluded that the franc is overvalued and should move towards 1.25 francs per dollar over time. According to Big Mac prices, there is a similar overvaluation in Germany.

Arbitrage only works on tradable goods

The problem is that the Big Mac index is not suitable for applying purchasing power parity theory. Although the burger has become the standard in Jakarta and looks the same as in Berlin, it cannot be traded. In the border region, Swiss people can go to Germany to eat, but other than that, there is no arbitrage opportunity. It is not possible to import finished Big Macs from the USA to Switzerland. At least no one wants to eat hamburgers like that.

Therefore, alternative price comparison indices based on the Big Mac index were invented. For example, the Mini Mac directory, which uses the price of a mini iPad from Apple as a benchmark, or the Billy directory, which refers to the classic Ikea frame. But research has shown that even better indicators for comparing price levels do not support the absolute purchasing power parity thesis. Shipping costs and customs duties are very high, and consumption habits in each country are very different.

It is the relative price change that matters.

And so science focuses more on the so-called relative purchasing power parity. It states that the exchange rate does not reflect the price level of the two countries, only their different developments. If inflation is higher in Germany than in Switzerland, it weakens against the euro franc.

Of course, this is not always the case because there are other factors that affect exchange rates, such as interest rates or external shocks. However, there is a consensus in the research that the relative PPP is sustainable, at least in the long run, that is, after a certain period of time, currencies return to the exchange rate that reflects the inflation differentials.

The euro-franc exchange rate is a good example to illustrate relative purchasing power parity. Since the introduction of the euro as a cash currency in January 2002, consumer prices in the euro area have increased by more than 50 percent, while cumulative price growth in Switzerland has been only around 13 percent. In the same period, the euro lost 40 percent of its value against the franc.

Inflation rates can also be used to represent an imaginary, theoretical exchange rate. It is the fair rate or equilibrium rate at which the relative purchasing power parity is met.

reference point problem

Relative purchasing power parity says nothing about the level of purchasing power, as it expresses the evolution of prices. To assess whether a currency is overvalued or undervalued, an assumption must be made about how fair the exchange rate was previously. So it needs a starting point. It is also called the reference point problem.

A historical average is often used for this. In this article, for the sake of simplicity, we set the starting point as January 2002. Therefore, we assume that there was no under or overvaluation at the time the euro was introduced.

According to this model, today’s fair euro exchange rate would be slightly above par at CHF 1.06 per euro. Frank is therefore overvalued, but not dramatically. Of course the result will vary if a different starting point is chosen. The choice of price indices also plays a role.

Precision landing with manufacturer prices

Many economists prefer producer prices because consumer prices include many non-tradable goods and, above all, services. But for the period from 2002 to the present, the result is quite similar. After all, producer prices in Germany – nonexistent for the entire currency union – actually rose much faster than in Switzerland, where they had fallen for several years.

According to this relative development, the euro should be at par. Or to put it another way: he finds the franc very valuable given producer price inflation.

The same considerations lie behind the so-called real exchange rates. Rather than comparing the effective exchange rate to a theoretically fair exchange rate, the effective exchange rate is adjusted for the inflation differential. An example of this is the real exchange rate indices that the SNB calculates. The time series is indexed to 100 at the end of 2000.

This presentation looks good: the strength of the Swiss franc reflects the difference in inflation, not much has really happened since the euro crisis in 2011. Since the franc shock in 2015, when the National Bank raised the minimum exchange rate of 1.20, the franc has lost some value in real terms. That’s why things got so quiet about the nominal strength of the franc. Recently, the Central Bank was even willing to sell its foreign exchange reserves, which tended to support the franc. The fear of overvaluation is gone.