It’s natural to want to know where you stand in the economy and get ahead of any big changes. It’s no surprise, then, that we’re hearing plenty of talk about whether the U.S. economy is in a recession.

As usual, we begin our inquiry with FRED data! The graph above displays, month after month, the estimated probabilities that the U.S. economy is in recession. These estimates are calculated from a set of economic statistics discussed in this article. The FRED graph also conveniently displays shaded bars when actual recessions occurred, as determined by the NBER business cycle dating committee. And the match up is astonishingly good! (For a deeper analysis, see this article.)

So, are we in a recession or not? You can judge for yourself; but at the time of this writing, the June 2022 data do not seem to indicate a recession.

Keep in mind that economic data can take a little while to arrive, conditions can quickly change, and our current economic situation is certainly different from previous ones. Thus, we can’t exclude the possibility that the model may be off target this time, but we can consider our own sense of the probability of that being true.

How this graph was created: Search FRED for “recession probabilities.”

Suggested by Christian Zimmermann.

The euro hit “parity” with the U.S. dollar for the first time in nearly 20 years on Wednesday, July 13, 2022. That is, the exchange rate dropped to $1.00 per euro. It quickly rebounded and has been hovering around $1.02 at of the time of this writing. What are the forces behind these changes, and how might we use data to illustrate them?

Interest rate parity theory suggests that the interest rate in the U.S. should equal the interest rate in the eurozone, plus the expected depreciation of U.S. currency. The basic assumption underlying this theory is that there is no arbitrage between deposits in different currencies. Thus, if interest rates are higher in the U.S. than in the eurozone, then it has to be the case that the dollar will eventually depreciate (i.e., lose value) vis-à-vis the euro. If markets are expecting the U.S. dollar to depreciate tomorrow, today’s value tends to be high. Thus, exchange rates tend to broadly follow movements in the difference between interest rates.

We see in the FRED graph above that, especially in the more recent period, the dollar-to-euro spot exchange rate tends to fall when the difference between the federal funds rate and the ECB deposit rate is positive. When this exchange rate is lower, the dollar is more valuable relative to the euro.

What does the lower exchange rate mean for U.S. consumers? The lower exchange rate, or the stronger dollar, will allow holders of U.S. currency to get more euros, and thus products in Europe are cheaper than usual. Typically, a strong domestic currency is good for consumers because importing products is cheaper; but it’s bad for domestic producers because international customers have to pay more for domestic exports.

How this graph was created: We take the first line as the federal funds rate (FEDFUNDS), click on “Edit Graph,” add the series for the European central bank rate for the euro area (ECBDFR), and apply the formula a-b. Then add a second line in the “Add Line” tab and put in the dollar-euro spot exchange rate (DEXUSEU) and change this line to the right axis in the “Format” tab.

Suggested by Miguel Faria-e-Castro and Samuel Jordan-Wood.

Part of the “My favorite FRED graph” guest post series.

“Under the skin of any international economist lies a deep-seated belief in some variant of the PPP theory of the exchange rate.” —Dornbusch and Krugman (1976)

Most models in international macroeconomics assume purchasing power parity (PPP) holds in the long run. But what is PPP and what is the long run?

A good starting point is the law of one price (LOP), which states that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important. Intuitively, LOP holds because, if prices were lower in country A and higher in country B, people would simply buy the lower-priced good in country A and sell it in country B at a higher price.

Purchasing power parity (PPP) is the application of LOP across countries for all goods and services—or for representative groups (“baskets”) of goods and services such as those used to compute the consumer price index. If absolute PPP holds, a typical basket of goods in country A has exactly the same price as it does in country B, when prices are expressed in a common currency.

Consider the case of Switzerland and the United States:

If P(CH) is the level of average prices in Switzerland, P(US) is the level of average prices in the U.S., and E is the Swiss franc/U.S. dollar exchange rate (number of francs per U.S. dollar), then absolute PPP holds if P(CH) = E · P(US).

PPP thus implies that the exchange rate is determined by the ratio of average prices.

If LOP holds for all goods and services, PPP will also hold. But there are good reasons why LOP doesn’t hold for all goods and services. Certain services (think of haircuts or restaurant meals) cannot be traded across countries. Certain goods are costly to transport (think cement). And certain goods have tariffs. For instance, meat is much more expensive in Switzerland than in Italy, France, or Germany, but a person can’t legally import large quantities of meat into Switzerland without paying large import duties.

Moving from the law of one price to purchasing power party is also complicated by the fact that people in different countries consume different goods. This is partly due to local tastes (more wine in Italy and more beer in Germany), but also income levels (in poorer countries, the typical household allocates a larger share of their expenditures to food). Absolute PPP doesn’t hold, as shown by the fact that PPP exchange rates normally deviate from nominal exchange rates.

A less-rigorous version of PPP is relative PPP, which states that the percentage change in the exchange rate is equal to the difference in the percentage changes in average prices—that is, the inflation rate. (Formally: (E_t-E_t-1)/E_t-1= π(CH)_t-π(USA)_t, where π(x)_t is the inflation rate in country x at time t.)

Relative PPP doesn’t hold at any one moment in time because the exchange rate is much more volatile than the average price level. However, standard economic models assume it holds in the long run—that is, when prices have had the time to adjust. There seems to be a consensus in the literature that in the “long-run PPP may hold in the sense that there is significant mean reversion of the real exchange rate, although there may be factors impinging on the equilibrium real exchange rate through time” (Taylor and Taylor, 2004).

The FRED graph above looks at the case of Switzerland versus the United States. The blue line plots the ratio between Swiss and U.S. prices (the ratio is rescaled so that it takes value 100 in 1990). The negative slope shows that Swiss inflation has been substantially lower than U.S. inflation. The ratio between Swiss and U.S. prices has decreased by about 73%. The green line plots the behavior of the exchange rate between the Swiss franc and the U.S. dollar rescaled to take value 100 in 1980. It shows that over 1970-2021 the Swiss franc appreciated by about 75%, which matches the behavior of relative prices. Over this 50-year period, PPP between U.S. and Switzerland seems to hold.

How this graph was created: Search FRED for and select “Switzerland CPI.” From the “Edit Graph” panel, use the “Add Line” tab to search for and select “CPI USA.” Apply formula a/b and at the bottom choose the “Index” as the unit, applying 100 for 1990-01-01. Use the “Add Line” tab to search for “Switzerland USA exchange rate” and apply 100 for 1980-01-01.

Suggested by Ugo Panizza.