Federal Reserve Economic Data

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.

When a commercial bank borrows from its District Federal Reserve Bank, it is using the Fed’s discount window. As described by the Board of Governors, this lending program provides commercial banks with short-term liquidity to support the smooth flow of credit to households and businesses. The operation of the discount window has evolved in response to the changing needs of the economy and financial system, and this FRED Blog post looks at its history through the lens of data.

The FRED graph above shows the interest rate that financially sound commercial banks pay when borrowing from the Federal Reserve. It is called the “discount window primary credit rate” because it offers the best credit terms to qualifying depository institutions. The daily data series starts on January 9, 2003, when the primary and secondary discount window program started making liquidity available to more commercial banks under different terms and at different costs. The source of the data is the Board of Governors.

But the discount window has been in operation since 1914, when the Federal Reserve System was established. Do you want to know how this tool of monetary policy operated further back in time? Keep on reading.

Before the primary and secondary credit programs were put in place, the Fed determined access to short-term liquidity for commercial banks through the adjustment and extended credit programs. There was and still is a third, seasonal  credit program not discussed here. The FRED graph above adds a second line (in red) to our initial graph. It shows the monthly average discount rate on loans to member banks and it extends the data back in time to January 1950. Note that the data source is listed as the International Monetary Fund, but the original data are reported by the Board of Governors through the Data Download Program.

Between 1914, when the Federal Reserve System was established, and the first half of 1922, when Federal Reserve District banks started buying large amounts of government securities in the open market, management of the discount window was intended as the principal instrument of central banking operations.

The FRED graph above adds a third line (in green) to our second graph. It shows the values of the basic discount rate that the Federal Reserve Bank of St. Louis charged to its member banks between November 16, 1914, and the launch of the primary and secondary discount window program in 2003. Notice that the data have no consistent frequency, as they were recorded only when the interest rate changed. Subject to approval by the Board of Governors, each of the 12 Reserve Banks in the Federal Reserve System can set its own discount rate. In practice, since the 1930s, the rates of the 12 Reserve Banks have rarely differed, and then only for a day or two. However, before 1933, there were more often differences in the rates across the Banks.

How these graphs were created: To create the first graph, search for and select “Discount Window Primary Credit Rate.” To create the second graph, from the “Edit Graph” panel, use the “Add Line” tab to search for and select “Interest Rates, Discount Rate for United States.” To create the third graph, repeat the last step to add “Federal Reserve Bank of St. Louis Basic Discount Rate (DISCONTINUED)” to the graph.

Suggested by Diego Mendez-Carbajo.