In our last post we highlighted some of the shortcomings of conventional proxies for inflation. Another popular way to measure the value of the dollar uses exchange rates between the dollar and other currencies. An index such as the dollar index is superior in that instead of portraying inflation as an increase in the cost of goods and services, it’s explicit in the value of the dollar, which is the real underlying issue in rising prices. It’s also a real time measure in that it reflects changes in the value instantly as opposed to just their cumulative effects over time. Yet it still falls short in that it doesn’t distinguish between genuine changes in the value of the dollar and changes in the value of the currencies it uses to measure them with. If for example the dollar index rises 3% over the course of a year, does that mean the dollar became 3% more valuable? Or that the other currencies collectively became 3% less so?
So ideally in order to measure changes in the value of the dollar, we would have a measure that combines the benefits of both approaches. It would select for actual changes in the value of the dollar, and also be a real time measure in which changes in the value of the dollar over aren’t artificially distinguished from the cumulative effect of changes over shorter time frames. The FDI has been developed for this purpose.
The following is a chart of the FDI since the beginning of 2000. In this rendering, the index is plotted as the natural log of the value of the US dollar, taking the value at the beginning of 2000 as the unit. The vertical axis is therefore a rough indication of percentage changes in the value of the dollar; for example in the 2008 spike the dollar increased in value on the order of 25%.
Financology Dollar Index
Other time frames and updates are posted under the Market Analysis item on the site menu.