The “law of one price” holds that identical goods should trade for the same price in an efficient market. But how well does it actually hold internationally? The Economist magazine’s Big Mac Index uses the price of McDonald’s Big Macs around the world, expressed in a common currency (U.S. dollars), to measure the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose.
But the law of one price assumes there are no restrictions on, or costs involved in, the movement of goods, and Big Macs travel badly. So in 2013 we created our own Mini Mac Index, which compares the price of iPad minis across countries. Minis are a global product that, unlike Big Macs, can move quickly and cheaply around the world. As explained in the video here, this fact helps equalize prices.
As shown in the graphic at the top, the Mini Mac Index suggests that the law of one price holds far better than does the Big Mac Index. The Big Mac shows the dollar overvalued against most currencies by an average of 21 percent (a whopper). By contrast, the Mini Mac shows the dollar undervalued—7.5 percent on average (small fries).
Since August 2022, the dollar’s valuation, as measured in minis, has plummeted 11 percentage points. This represents a large swing after a year-on-year jump of 10 percentage points from August 2021 to August 2022. The 2022 rise in the dollar’s valuation can be attributed to aggressive Fed rate hikes and a more sluggish response to inflation in Europe. The more recent reversal owes largely to the market’s judgment that the Fed is nearing the end of its tightening cycle—given the steady decline in inflation, regional bank troubles, and fears of recession.
In contrast to the dollar, the valuations of European currencies have spiked. Since August 2022, the British pound has risen 25 percentage points in its Mini Mac valuation, from a 4 percent undervaluation to 21 percent overvaluation, reflecting falling gas prices, an improving economic outlook, and expectations of higher interest rates to combat inflation. The euro also gained 25 percentage points after its 2022 fall during the European energy crisis. In wholesale contrast to other European currencies, Norway’s krone fell 22 percentage points amidst slowing interest-rate hikes and unrest in banking.
China’s renminbi gained 2 percentage points over the last year, climbing from a 3 percent to a 1 percent undervaluation after the end of its “Zero Covid” policy. Thailand’s baht, Indonesia’s rupiah, South Korea’s won, and the Philippines’ peso have all climbed against the dollar from undervaluation in August 2022 to overvaluation now.
And going forward? Guessing currency moves is a fool’s game. But our McMetric, the less cheesy of the two, suggests the dollar is due for a boost.