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 32 percent (a whopper). By contrast, the Mini Mac shows the dollar slightly undervalued—2.7 percent on average (small fries).
The dollar’s Mini Mac valuation has climbed four percentage points over the past year, and 1.6 points since August. Driving this climb has been growing expectations of the Fed hiking interest rates a year earlier than it had forecast early on in the pandemic—the result of core PCE inflation rising from 1.5 percent last February to 4.9 percent in December. In consequence, investors now expect between four and seven rate increases this year, possibly taking the policy rate from 0 percent to 1.75 percent or more.
For currencies of other developed countries, which have seen somewhat smaller inflation gains than the United States, Mini Mac valuations have plunged. Since August, the UK pound fell from 16.1 percent overvalued to 8.1 percent overvalued, the euro dropped from 12.3 percent overvalued to 5.7 percent overvalued, and the Japanese yen sank from 4.6 percent overvalued to 5.3 percent undervalued.
In contrast, the Chinese RMB’s Mini Mac value has, like that of the dollar, risen of late. Since August, it has soared from a 2.3 percent undervaluation to a 3.1 percent overvaluation. Two factors are notable in this regard. First, the world has been buying more Chinese goods as global growth recovers from the pandemic. Second, foreign investment inflows have surged, particularly since FTSE Russell added China to its global government bond index last October. Facing these trends, the PBoC has allowed the RMB’s exchange rate to rise to its highest level since 2018.
The Mini Mac Index’s worst performer? No surprises here. Under growing threat of a Russian invasion, Ukraine has seen it hryvnia fall from 2.2 percent undervalued to 16.5 percent undervalued.