The Burning Platform

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Cornehlsen goes on to say, in part:

The Economist… created the Big Mac Index in 1986…[which] was created to compare the price of currencies between different countries. The index is based on the theory of purchasing-power parity, which says that exchange rates should eventually adjust to make the price of a basket of goods the same in each country. The Big Mac Index basket contains just one item: the Big Mac hamburger. It works by calculating the exchange rate that would leave a Big Mac costing the same in each country. 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.

Using the Big Mac Index to Measure Inflation

[For our purposes in this article,] rather than use the Big Mac index for comparing the value of currencies between countries, we… [have graphed] the price of the Big Mac within the U.S. each year since 1986 to see how it has change over time….[and it shows (see chart below) that] prices have accelerated much faster than the official reported Consumer Price Index (CPI) from the Bureau of Labor Statistics.

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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.

1. 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.
2. 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.

The Big Mac Index vs. the Consumer Price Index

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%….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)

Big Mac Index Implications Related to Inflation

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 be receiving $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….By understating inflation, the federal government is effectively reducing the amount owed to retirees and thereby cutting the long-term deficit.

Big Mac Index Implications Related to Bond Prices

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.
• If we base our calculation on the Big Mac Index, however, 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 should 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 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.

Conclusion

The price of a Big Mac is rising faster than the official rise in consumer prices and has been since the late 90′s….[and] 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.

[Bottom line:] 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….

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*http://advisorperspectives.com/dshort/guest/James-Cornehlsen-121217-Big-Mac-Inflation-Risk.php