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 (CPI), 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:

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 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 abroad.

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 (CPI) 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.

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.

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 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 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 Inflation

Lastly, Gross Domestic Product (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 1.26% 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?

Portfolio Update

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

Disclaimer: 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.