What is the real effective exchange rate?

The real effective exchange rate (REER) is a trade-weighted average of a country's currency against a basket of its trading partners' currencies, adjusted for relative inflation rates. Unlike the nominal exchange rate, which simply measures how many units of one currency you get for another, the REER accounts for the fact that different countries have different inflation rates, which affects the real cost of their goods and services in international markets.

The Bank for International Settlements (BIS) publishes REER indices for over 60 countries using both consumer price indices and unit labor cost deflators. A rising REER indicates that a country's goods and services are becoming more expensive relative to its trading partners, either because its nominal exchange rate is appreciating or because its inflation is higher than its partners. A falling REER indicates improving competitiveness.

The US dollar REER has been elevated by historical standards since the mid-2010s, reflecting both nominal dollar strength and higher US growth relative to other developed economies. This persistent overvaluation, by PPP-adjusted metrics, is sustainable as long as the structural demand for dollars (reserve currency status, safe-haven flows, higher real yields) continues. If that demand weakens, the REER could converge toward more historical norms, which would imply significant dollar depreciation.

For macro analysts, the REER provides context that bilateral exchange rates alone cannot. The dollar might strengthen against the euro but weaken against the yen in the same period; the REER aggregates these moves into a single measure of overall competitiveness. Countries with persistently overvalued REERs tend to develop current account deficits and may eventually experience currency adjustments, either through market forces or policy intervention. Central banks in export-dependent economies (Japan, South Korea, Switzerland) pay close attention to their REER when making monetary policy decisions.