Our Big Mac index of global currencies reflects the dollar’s strength
Emerging-market currencies and the euro look undervalued against the dollar
Jan 14th 2017
IT IS perhaps not surprising that the worst-performing major currency in the world this year is the Turkish lira. Many emerging-market currencies have taken a battering since the election in November of Donald Trump raised expectations of faster monetary tightening in America and sent the dollar soaring. But the lira has many other troubles to contend with, too: terrorist bombings, an economic slowdown, alarm over plans by the president, Recep Tayyip Erdogan, to strengthen his powers, and a central bank reluctant to raise interest rates to defend the currency. It has plunged to record lows. According to the Big Mac index, our patty-powered currency guide, it is now undervalued by 45.7% against the dollar.
The Big Mac index is built on the idea of purchasing-power parity, the theory that in the long run currencies will converge until the same amount of money buys the same amount of goods and services in every country. A Big Mac currently costs $5.06 in America but just 10.75 lira ($2.75) in Turkey, implying that the lira is undervalued.
However, other currencies are even cheaper. In Big Mac terms, the Mexican peso is undervalued by a whacking 55.9% against the greenback. This week it also plumbed a record low as Mr Trump reiterated some of his campaign threats against Mexico. The peso has lost a tenth of its value against the dollar since November. Of big countries, only Russia offers a cheaper Big Mac, in dollar terms, even though the rouble has strengthened over the past year.
The euro zone is also prey to political uncertainty. Elections are scheduled this year in the Netherlands, France and Germany, and possible in Italy. The euro recently fell to its lowest level since 2003. Britain’s Brexit vote has had an even bigger effect on the pound, which has fallen to $1.21, a 31-year low. According to the Big Mac index, the euro and the pound are undervalued against the dollar by 19.7% and 26.3%, respectively.
One of the drawbacks of the Big Mac index is that it takes no account of labour costs. It should surprise no one that a Big Mac costs less in Shanghai than it does in San Francisco, since Chinese workers earn far less than their American counterparts. So in a slightly more sophisticated version of the Big Mac index, we take account of a country’s average income.
Historically, this adjustment has tended to raise currencies’ valuations against the dollar, so emerging-market currencies tend to look more reasonably priced. The Chinese yuan, for example, is 44% undervalued against the dollar according to our baseline Big Mac index, but only 7% according to the adjusted one. The deluxe Big Mac index has typically made rich-world currencies look more expensive. Because western Europeans have higher costs of living and lower incomes than Americans, the euro has traded at around a 25% premium against the dollar in income-adjusted burger terms since the euro’s inception.
But what once seemed to be an immutable axiom of burgernomics is true no longer. So strong is the dollar that even the adjusted Big Mac index finds the euro undervalued. The dollar is now trading at a 14-year high in trade-weighted terms. Emerging-world economies may struggle to pay off dollar-denominated debts. American firms may find themselves at a disadvantage against foreign competition. And American tourists will get more burgers for their buck in Europe.
Inflation is on the way back in the rich world, and that is good news
Deflationary fears are at last on the point of being banished
Jan 14th 2017
IT WAS telling that Germany, a country with a phobia of rising prices, in the first week of 2017 reported a jump in inflation. Its headline rate rose from 0.8% to 1.7% in December. After two years of unusually low price pressures, inflation across the rich world is set to revive this year. Much of this is because of the oil price, which fell below $30 a barrel in the early months of 2016 but has recently risen above $50 (see chart). Underlying inflation, too, seems poised to drift up. That is good news. The story for 2017 is not of inflation running too hot but rather of a welcome easing of fears of deflation.
To understand why, consider the three big drivers of inflation in the rich world: the price of imports, capacity pressures in the domestic economy and the public’s expectations. Start with imported inflation. A year ago, global goods prices were falling because of a slide in aggregate demand and a seemingly endless glut of basic commodities and manufactures. China’s economy wobbled. Emerging markets in general were in a funk; two of the largest, Brazil and Russia, were deep in recession.
Things look perkier now. Emerging markets still have plenty of trouble spots, but the bigger economies are stabilising. After falling for 54 months, producer prices in China are climbing at last. Prices at the factory gate rose by 5.5% in the year to December. China’s supply glut, though still vast, is shrinking. An improving demand climate is reflected in upbeat surveys of manufacturing purchasing managers across Asia and in the rich world. It is also visible in a revival in commodity prices.
So rich countries are importing a bit more globally made inflation. How big an impact that has depends on the exchange rate. And in much of the rich world, currency markets are proving helpful. In America, where underlying inflation is close to 2%, the Federal Reserve’s goal, the dollar has risen. In Japan and the euro area, where underlying inflation is lower (see chart), the yen and euro have weakened.
The second big influence on inflation is the amount of slack (or spare capacity) in the domestic economy. The unemployment rate, measuring labour-market slack, is often a convenient gauge. On that basis, America’s economy, with unemployment at 4.7%, is close to full capacity. Average wages rose by 2.9% in the year to December, the highest rate since 2009. Assuming that trend productivity growth is around 1%, then wage growth of around 3% is consistent with a 2% rise in unit-wage costs, in line with the Fed’s inflation target.
The picture is cloudier in other parts of the rich world. Euro-area jobs markets are more rigid and run into bottlenecks more readily than America’s. Even so, the euro-area economy has far greater slack. The unemployment rate is 9.8%. The big southern euro-zone economies, such as Italy and Spain, have ample spare capacity. So if inflation is to get back to the European Central Bank’s target of close to 2%, it will require other economies, notably Germany, to generate inflation rates well above 2%.
That is not as implausible as the form book suggests. Germany has a tight labour market. The unemployment rate is just 4.1% and the workforce has shrunk as the population ages. And after a decade or more of restraint, wages have picked up a bit. Compensation per employee has risen at an average annual rate of 2.5% since 2010, according to the OECD, a rich-country think-tank. That is faster than in any other G7 country, but still not enough to drive German inflation up to the sorts of levels needed to push euro-zone inflation close to 2%. Faster wage growth has not fed through to higher consumer-price inflation, notes Ralf Preusser of Bank of America Merrill Lynch. Average core inflation has been around 1.1% since 2010. German firms have absorbed rising wage costs without increasing prices. In Japan, where the jobs market is even tighter, wage growth has struggled to reach even 1%.
That wages have not risen faster owes much to the third big determinant of inflation—expectations. Firms will feel freer to push up prices, and employees to bargain for bigger wage rises, if they expect higher inflation. In theory expectations are in the gift of central banks. If they can convince the public that they have the tools to regulate aggregate demand, and thus the level of slack, expectations should converge on the central bank’s inflation target, usually 2% in rich countries. But expectations are also influenced by what inflation has been recently. In rich countries, it has fallen short. Inflation expectations in financial markets have recently perked up, but in the euro area are still well shy of the target (see chart). In Japan, two decades of deflation have taught firms and wage-earners to expect a lot less than 2%.
Put the pieces of the jigsaw together and the following picture emerges. Headline inflation in the rich world is likely to rise quickly in early 2017, thanks largely to rising oil prices and a generally firmer global backdrop. Underlying inflation will grind up more slowly as above-trend growth eats away at available slack. A burst of stronger headline inflation this year might drive up inflation expectations and set the stage for bolder wage claims in northern Europe and Japan in 2018.
Analysts at JPMorgan Chase expect higher inflation to add one percentage point to global nominal GDP in 2017, spurring a revival in profits and setting the scene for a recovery in capital spending (even without tax cuts in America). Forecasters often now look for extreme outcomes, but rich-world inflation this year may turn out to be a tale of moderation: enough to grease the wheels, but not enough to upset the cart.
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