Courtesy of Doug Short.
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Extending our research on the use of the Big Mac Index, as created by The Economist, we applied the rise in the price of a Big Mac in relation to the overall economy. While Big Mac prices rose over the last three months, the price declined the past 12 months. The burger, as a representation of GDP, may be stealing more than calories from consumers.
The Bureau of Economic Analysis (BEA) reported that the economy grew 4.0%. This was ahead of the 3.2% the market expected as reported by Briefing.com, and this was a marked improvement from the newly revised -2.1% from the first quarter of 2014. As the BEA indicated in the press release “The increase in real GDP in the second quarter primarily reflected positive contributions from personal consumption expenditures (PCE), private inventory investment, exports, nonresidential fixed investment, state and local government spending, and residential fixed investment.”
The deflator used for inflation was up 1.9%, which was very close to the Consumer Price Index (CPI) of 2.1%. This resulted in the GDP number being slightly higher than it would otherwise be if the CPI was used.
Odds and Ends
The BEA defines gross domestic product, the measure of economic growth as:
GDP = private consumption + gross private investment + government spending + (exports – imports)
Taking it one step further, we can break this down to by private consumption into service and actual goods and investment into fixed investment (machinery) and inventories.
Quarterly Changes in % Contributions to GDP
SOURCE: http://www.consumerindexes.com/history.html
When looking at GDP with all its components, we can see that individuals and domestic investment improved significantly over the previous quarter. Doug Short graphically represents the components of GDP.
Burger Blues
Inflation boosts the growth rate of each of the components of GDP. When the price of food or gasoline increases, GDP increases. This is more accurately called “real” GDP.
Thanks to The Economist, we have come to look at the price of the Big Mac as a good indication of inflation. The Big Mac includes beef, dairy (cheese), wheat (bun), cost of labor, and the cost of real estate. As a result, I believe it is a good representation of inflation.
However, our analysis of the Big Mac indicates that the escalation of the price of a Big Mac has grown in recent quarters much faster than the official government rate of inflation (CPI-U). Consequently, here is a view of GDP in light of our analysis of prices using the Big Mac Index.
Previously, when including the price of the Big Mac, GDP growth has been exaggerated. We can see that GDP without the benefit of lower inflation has actually declined by more and for longer lengths of time than the official GDP numbers suggest. (Note that the last time we reported the GDP with Big Mac we had a larger spike due to using a higher annualized GDP deflator number than reported.)
Using inflation as measured by the Big Mac we see that growth in GDP is lower than reported by the BEA. The reported 4.0% growth rate falls to 1.3% in the second quarter.
Further, the BEA revised the GDP growth down for the period from 2011 to 2013 to 2.0% from 2.2%. In both 2011 and 2012, the revisions lower were due to lower personal consumption expenditures. Might this have been for due to higher inflation? During this time the GDP deflator rose at an average rate of 1.8% while the Big Mac increased at a rate of 5.1%.
When you compile GDP by using the government’s provided consumer price index (CPI), you get divergences both above and below the official figure on GDP.
Source http://www.consumerindexes.com/history.html
Richard Davis, the founder of Consumer Indexes, has graphed the differences between the official stated GDP index and GDP compiled with CPI (above). In the last four years, the divergences using the CPI for inflation have caused the GDP to be higher, as the current quarter shows, as well as Quarter 2 2010; Quarter 2, 2012 and lower than GDP,Quarter 3, 2009; Quarter 1 2011; and Quarter 3, 2012.
For another view of how GDP is compiled using different “official” rates of inflation, go to Doug Short’s analysis. In his work, Short concludes that using an alternate CPI compiled by Shadowstats was too negative and may significantly understate growth in the economy.
The Real Truth
My conclusion is twofold. First, many, many people in the US and around the world rely on Big Macs as sustenance. If this is what they are experiencing in escalating food prices, it should be incorporated into the measure of inflation and GDP growth. Second, financial advisors should be aware of the differences in inflation. When running projections and creating financial plans, they should consider what individuals actually experience for inflation and what the government puts out in the form of CPI-U and in the GDP numbers may not reflect what the consumer experiences. Therefore, financial advisors should understand the differences so that they can help a person plan for one’s retirement rather than have the hamburglar steal a portion of one’s retirement.
Next Steps
Study the differences in GDP and learn how to advise your clients in a manner that best prepares them for the changes in the real consumer experience. Stay tuned for updates from AUM in a Box about GDP, inflation and more.
NOTES:
Quarterly GDP dates from 1947; Big Mac Index from The Economist began in 1986, but did not become consistent until Q2 1990. The Economist update Big Mac prices once or twice a year.
Real GDP is quarterly annualized to compare against the annual change in Big Mac prices.
Originally posted at AUM in a Box
© James Cornehlsen, CFA
Dunn Warren Investment Advisors, LLC
http://www.dunnwarren.com
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