UPDATED AUGUST 2014: Why the Big Mac’s Rising Prices Are More Alarming Than Its Fat Content

Posted By on Aug 19, 2014|6 comments


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 and the most recent CPI for August 2014 (which was released on August 19, 2014) .

What are we to believe? The change in the price of the Big Mac says one thing while the Bureau of Labor Statistics is telling us another.

On Tuesday, August 19, the Consumer Price Index (CPI) was released by the Bureau of Labor Statistics, stating that “Over the last 12 months, all the items in the index increased 2.0 percent before seasonal adjustment.”

The rise in the price of a Big Mac 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. As of July 24, 2014, The Economist reports that the price of a Big Mac is $4.80. If we were using the Consumer Price Index (CPI), the price of a Big Mac today should be about $3.67.

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:

  1. Each dollar we own is buying less.
  2. For individuals relying on Social Security, the compensation for inflation is not keeping up with the prices people actually pay.
  3. The price of bonds should be much lower if interest rates fully accounted for the rise of inflation based on the Big Mac.
  4. 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 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, 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.

A comparison between Big Mac prices and CPI as of August 2014.

Since 1986, the price of a Big Mac has increased 200% from $1.60 to $4.80 today. During this same time period, the CPI has increased at a much lower rate of 117%. 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 three pieces and only eat one of the three pieces for $1. Consequently, each dollar we have is buying a lot less.

 

1986 Big Mac Prices2014 Big Mac prices

 

 

 

 

 

 

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 $1,410 today.  In contrast, if the Big Mac Index were used, beneficiaries would receive $1,970. By using the CPI, the government is paying out $560 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 2.3%. 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 2%. Adding 1% for the increased risk of holding a bond for 10 years gives you a rate of at least 3%, and that’s using official inflation estimates. However, if we base our calculation on the Big Mac Index, inflation is 9.6% and adding 1% to that for the risk of holding a bond for 10 years gets a rate of 10.6%. The current interest rate of a government bond is 2.3%, 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 10.6%. Consequently, if 10-year government bonds were to increase from 2.3% to 10.6%, bond indices would decline by about 64%. In other words, long duration, 10-year government bonds are overvalued by about 64% mainly due to persistent intervention (manipulation) by the Federal Reserve.

Propping Up GDP Numbers by Underestimating Inflation

Lastly, let’s look at Gross Domebig mac index inflationstic 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 4% and cause the report to show that GDP was 8% lower at minus 4%. 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?

Implications for Financial Advisors 

As a coach to financial advisors, I believe that there are two main implications to point out.

  1. First, realize that costs are increasing faster for clients than the government suggests. Therefore, individuals need more income to sustain the same level of consumption they have had in the past.
  2. Second, Easterling believes that the value of the stock market is predicated on the level of inflation. However, if inflation is higher, or lower, than what is reported, does that make valuations of the stock market unstable than they already are?

Recently, Easterling wrote in “Nightmare on Wall Street: This Secular Bear Has Only Just Begun”:

Now, finally, the stock market is fairly-valued for conditions of low inflation and low interest rates (assuming average long-term economic growth in the future). But what about the future?  If inflation remains low and stable indefinitely, then this secular bear will remain in hibernation until the inflation rate runs away in either direction. July 1, 2012 (Updated October 1, 2013)

What if inflation is already above the level to support heightened valuations for the stock market? Does that mean that the stock market could lose its lofty stance quicker?

Certainly this is a possibility and further justifies ongoing tracking of the Big Mac as the inflation measure of choice for financial advisors to use with your clients.

 

photo credit: Simon Miller via photopin cc

However, since its invention in 1986, you can see on the internet that a whole cottage industry has sprung up from this concept. At first, it was to find that ideal arbitrage trade. But investors should take the Big Mac Index for what it was intended

6 Comments

  1. Another thing to compare it to is minimum wage. I was listening to a news thing recently where they were talking about how many billions of dollars one fast food place was making, and they saying “shouldn’t someone making that much money pay their employees more money”? My response is “shouldn’t they charge less”?

    The wages in America for the workers – whether minimum wage or working class – are not keeping up with the cost of living. But the people at the top of the organizations are making absurd profits making everything less and less affordable, killing the middle class.

    We’ve sent manufacturing over seas to “save money”. But those savings aren’t passed on to the consumer. And it’s very energy inefficient. And it leaves jobs like telemarketing, retail and food service as the only employment options for many Americans. Who’s really proud of that? I think there is much more pride in manufacturing: at the end you can say “I built that”.

    The peeps at the top have the rest of us squeezed in a vice.

    Post a Reply
    • Lynn,

      You bring up a good point. Actually two: Earnings disparity and employment options for Americans.

      Thanks for your feed back.
      Jamie

      Post a Reply
    • I’ve heard that in high debt driven economies (which ours is) that economic wealth will inevitably be concentrated in the hands of a few who are able to exploit such a system. In other words, the problem isn’t that people don’t make enough, it’s that stuff costs too much.
      Why does it cost so much? Bank money printing (in this era by the Fed bank to buy government debt).
      Who benefits the most? Those who get the newly issued dollars first or very close to it.

      Post a Reply
      • I have thought is strange that we continue to call Quantitative Easing as printing of Money. It is a Accounting ledger item – for as much as the government prints, what is happening is that the money center banks are lending to Federal Reserve money. in return the banks are getting interest payments. In addition they are getting service fees for brokering the bonds. As a result they are getting bailout without calling it a bailout, but is has enabled the money center banks to repair their balance sheets

        Post a Reply
  2. I think we should have a “Wendy’s Value Chili Index” or a “Wendy’s Jr Bacon Cheeseburger Index.”

    Both of these were $1.00 just last year. The chili is now $1.69 and the Jr. Bacon is $2.00.

    I get that wholesale beef is more expensive this year but a 70% rise in price and a 100% rise in price seems out-out-touch.

    Post a Reply
    • You are right Brian. I think the original prices were to get people in the door, but it is a dramatic price increase any way you look at it.

      Post a Reply

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