By James Cornehlsen, CFA
The rise in the price of a Big Mac is faster than the official
rise in consumer prices and has been since the late 90's. In 1998,
the average price of a Big Mac was about $2.50. Today, the average
Big Mac is $4.33. If we were using the Consumer Price Index ((
)), the price of a Big Mac today would be about $3.35. See the
graph below. The price hikes represented by this popular burger
will impact individuals more than the saturated fat content that
Big Macs bear.
The rise in the price of the Big Mac foreshadows how the
printing of money is eroding the financial system's arterial walls.
The impact is broad based:
- Each dollar we own is buying less.
- For individuals relying on Social Security, the
compensation for inflation is not keeping up with the prices
people actually pay.
- The price of bonds should be much lower if interest rates
fully accounted for the rise of inflation based on the Big
- The official economic growth rate would be lower now if
prices were based on the Big Mac Index.
Using the Big Mac Index to Measure Inflation
The Economist Newspaper created the
Big Mac Index
in 1986. The Big Mac Index was created to compare the price of
currencies between different countries. The index is based on a
theory called purchasing-power parity. This theory looks at the
same basket of goods in each country and then adjusts for the
interest rate one would pay for a loan or get for a savings
account. This adjustment for interest rates makes the price of a
Big Mac comparable in each country. The Big Mac index just has one
item; however, because it contains beef, dairy (cheese), wheat
(bun), cost of labor, and the cost of real estate, I believe it is
a good representation of prices in the United States and
Rather than use the Big Mac index for comparing the value of
currencies between countries, we wanted to take the price of the
Big Mac each year within the US to see how it changes over time.
You could also use this approach to look at the trend of prices for
other countries as well.
By graphing the trend of the Big Mac index each year since 1986,
we are shown that prices have accelerated much faster than the
official reported Consumer Price Index ((
)) from the Bureau of Labor Statistics. On the BLS's website, CPI
is defined as "a measure of the average change over time in the
prices paid by consumers for a market basket of consumer goods and
services. The basket includes food & beverages, housing,
apparel, transportation, medical care, recreation, education &
communication, and other goods & services". However, there are
two broad concerns with the CPI. First, CPI accounts for the
substitution effect whereby if the price of beef increases, it is
assumed that fewer people will buy beef and will instead buy
chicken. Second, there is a "chained" effect meaning the basket of
goods isn't consistent from one time period to the next. The reason
for this is that it is believed people change their spending habits
as prices change which is why the bureau of Labor Statistics
instituted this policy.
(click to enlarge)
Since 1986, the price of a Big Mac has increased 171% from $1.60
to $4.33 today. During this same time period, the consumer price
index has increased at a much lower rate of 109%. More
disconcerting is the effect of aggressive adjustment of monetary
policy by the Federal Reserve, beginning in 1999. This policy shift
started with the Asian crisis and Long Term Capital Management,
followed by the Internet bubble, housing bubble, and Great
Recession, and now the "New Normal" of zero federal funds rates and
quantitative easing. In the context of these Fed policies, the rate
of price increases for the Big Mac is almost three times greater
than the official Consumer Price index.
In 1986, $1 would have purchased over half of a Big Mac. Today
you would have to cut the Big Mac into five pieces and only eat one
of the five pieces for $1. Consequently, each dollar we have is
buying a lot less.
(click to enlarge)
Hidden Cuts to Benefits
Individuals on Social Security are provided a cost of living
index. This index is based on the Consumer Price index. If an
individual received $1,000 per month in 1999, they are receiving
$1,360 today. In contrast, if the Big Mac Index were used,
beneficiaries would receive $1,770. By using the consumer price
index, the government is paying out $410 less than they would
otherwise pay based on the rise in the price of a Big Mac.
Throughout history, it has always been much easier for governments
to quietly inflate away their excess liabilities rather than
attempt outright cuts and painful austerity. The streets of Europe
are a present day example of the social difficulty of outright
cuts. By understating inflation, the federal government is
effectively reducing the amount owed to retirees and thereby
cutting the long-term deficit.
Bond Prices and Inflation
In a normal market, the price of bonds should reflect the rate
of inflation. Ed Easterling, founder of
, links inflation to the rate of interest rates. By printing money
to buy bonds, the government has pushed the interest rate of a
10-year government bond down to about 1.70%. However, Ed Easterling
shows that the 10-year government bond rate should be about 1%
above inflation. The current rate of inflation reported by CPI is
1.1%. Adding 1% for the increased risk of holding a bond for 10
years gives you a rate of at least 2.1%, and that's using official
inflation estimates. However, if we base our calculation on the Big
Mac Index, inflation is 3.1% and adding 1% to that for the risk of
holding a bond for 10 years gets a rate of 4.1%. The current
interest rate of a government bond is 1.7%, but if we were to
account for inflation as seen by the rise in the price of a Big
Mac, the interest rate would be 4.1%. Consequently, if 10-year
government bonds were to increase from 1.7% to 4.1%, bond indices
would decline by about 20%. In other words, long duration, 10-year
government bonds are overvalued by about 20% mainly due to
persistent intervention (manipulation) by the Federal Reserve.
Propping Up GDP Numbers by Underestimating
Lastly, Gross Domestic Product ((
)) is the measure used for the growth rate of the overall economy.
GDP is adjusted for inflation. An understatement of assumed
inflation makes the reported GDP headline number look better, and
conversely an overstatement makes the calculated growth rate look
worse. Using the Big Mac Index instead of the official CPI would
reduce the latest GDP growth rate of 1.26% and cause the report to
show that GDP declined. Consequently, economic growth looks
stronger using CPI rather than the Big Mac Index.
As a result, investors are being penalized (mostly without their
knowledge) with higher inflation, lower income from bonds and
certificates of deposit and being led to believe that the economy
is growing better than it really is.
The risk of too much debt around the world, but specifically in
Europe, is reducing the growth outlook for companies. In China, the
government has cut spending to keep inflation in check and their
economy is now slowing down. In the last thirteen years, three
bubbles have emerged, each funded by the government artificially
lowering interest rates and printing money. Each subsequent
contraction has been worse than the last. Why should this latest
bout of artificial growth, which is even steeper than the previous
three, end differently?
We challenge investment beliefs and the status quo by measuring
risk. We are able to grow money if we reduce the downside caused by
recessions. Currently we find the investment environment is very
similar to 2000 and 2008. The upside does not outweigh the downside
risk. In fact, the return over the last 3 years has been
historically erased in a downturn.
There is a great deal of discussion about the Fiscal Cliff.
While we are worried about the Fiscal Cliff, our concerns are
broader. First, valuations for the Stock market are 30% to 40%
above fair value. Second, the economy is decelerating and in Europe
is declining. Historically, the combination of high valuations and
a decelerating/declining economy causes a loss of 30% to 60% in the
value of stocks that wipes out all of the gains in the stock market
over the last three to five years.
Since our last writing, we have added 10% to short term
government bonds. Note that we are purchasing short-term government
bonds rather than long-term government bonds. We are doing this
because of the risk we outlined above; long-term government bonds
are currently overvalued. We are certainly not soothsayers, we are
just judging whether risk exists or not, and if risk exists what
loss could transpire. We believe the loss potential is great, as
the last three bubbles resulted in prices giving back the previous
five years of gains.
(c) James Cornehlsen, CFA
Dunn Warren Investment Advisors, LLC
The opinions expressed here are based on the author's views
and should not be construed as financial advice. Model results do
not represent actual trading and may not reflect the impact that
material economic and market factors might have on the advisor's
decision-making if the advisor were actually managing a client's
money. Past performance is no guarantee of future performance.
There can be no assurance that a client's investment objective
will be achieved or that a client will not lose a portion or all
of his or her investment. Please contact Dunn Warren directly for
a list of the recommendations provided over the last year.
Investing outside the United States involves additional risks,
such as currency fluctuations, periods of illiquidity and price
volatility. These risks may be heightened in connection with
investments in developing countries.
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