Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Note: I've updated my periodic look at the Consumer Price Index (CPI) versus the Big Mac Index to coincide with The Economist's bi-annual update of the Big Mac Index used for currency values.
In a time when price hikes are commonplace, I took a step back and realized that some prices are rising more than others. The price of a Big Mac, for instance, has risen faster than the official rise in consumer prices and has been doing so since the late '90s. In 1998, the average price of a Big Mac was about $2.50. Today, the average Big Mac is $4.56. If we were using the Consumer Price Index (CPI), the price of a Big Mac today should be about $3.40.
Believe it or not, the price hikes represented by the Big Mac will impact you more than the saturated fats in popular burger. By understanding the price disparities, you can make better decisions for you and your clients. 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 Mac.
- 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 Economistcreated 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, since the one item 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 abroad.
Rather than use the Big Mac Index for comparing the value of currencies between countries, let's 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 see that prices have accelerated much faster than the official prices reported Consumer Price Index (CPI) – Bureau of Labor Statistics. On the Bureau of Labor Statistics' 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 revised CPI to account for substitution and the "chained" effect.
Since 1986, the price of a Big Mac has increased 185% from $1.60 to $4.56 today. During this same time period, the CPI has increased at a much lower rate of 110%. More disconcerting is the effect of the aggressive adjustment of monetary policy by the Federal Reserve, which began 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 CPI.
In 1986, $1 would have purchased more than 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.
Hidden Cuts to Benefits
So how does this price disparity play out in retirement benefits? Individuals receiving Social Security benefits are provided a cost of living adjustment based on the cost of living index. This index is based on the CPI. 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 CPI, 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
And what about bond prices and inflation? In a normal market, the price of bonds should reflect the rate of inflation. Ed Easterling, founder of Crestmont Research, 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 2.61%. 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 3.7%, and that's using official inflation estimates. However, if we base our calculation on the Big Mac Index, inflation is 5.3% and adding 1% to that for the risk of holding a bond for 10 years gets a rate of 6.3%. The current interest rate of a government bond is 2.61%, 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 5.3%. Consequently, if 10-year government bonds were to increase from 2.6% to 6.3%, bond indices would decline by about 32%. In other words, long duration, 10-year government bonds are overvalued by about 32% mainly due to persistent intervention (manipulation) by the Federal Reserve.
Propping Up GDP Numbers by Underestimating Inflation
Lastly, let's look at Gross Domestic Product (GDP). GDP 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 1.8% 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 13 years, three bubbles have emerged, each funded by the government and each artificially lowering interest rates by 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?
Take at look at the trends and put policies in place to safeguard you and your clients against the price hikes reflected by the Big Mac Index.
This story originally ran in Dunn Warren Investment Advisors' December Newsletter.