Dollar pickle: What the Big Mac index says about the Australian currency

The Australian dollar is undervalued by close to 10%, according to the latest Big Mac index from The Economist.

The index, which compares the price of a McDonald’s Big Mac in the US with the price of the hamburger in a range of other countries, is based on the premise of purchasing-power parity. That is, over time, exchange rates will adjust so that the price of goods and services in one country is the same as in any other country.

Based on the January prices, a Big Mac will set an Australian back $US4.32 at market exchange rates, while diners in the US would be charged $US4.79. Therefore, according to the index, the Aussie dollar is undervalued by 9.8%.

This compares to the Swiss franc, which according to the index is overvalued by 57.5%, and the Indonesian rupiah, which is undervalued by 53.3%.

In July last year, the same index said the Aussie dollar was just about where it should be, with the cost of a Big Mac in Australia coming in at $US4.81 at market exchange rates, compared to $US4.80 for the same hamburger in the US. That amounted to an overvaluation of the Australian currency of just 0.4%.

The price of the dollar has been in a steady decline since then and is currently buying just above US80 cents.

But Matt Richardson, corporate dealer at OzForex, says while the Big Mac index is a good comparison tool for assessing the purchasing power of individual currencies, it is not necessarily an accurate tool to assess the Australian economy as a whole.

“The Reserve Bank has over the last few months indicated it would like to see the dollar around the US75 cents mark and it did dip below the 80 cents marks earlier this morning,” Richardson told SmartCompany.

“The RBA still see the dollar as being overvalued and believes it needs to reach the mid-70s level for more stable growth in the overall economy, especially in the mining sector with falling commodity prices.”

Richardson says OzForex expects the dollar’s downward trend to continue this year in the face of a strengthening US economy.

“The International Monetary Fund said last week it expects the US economy to continue to grow in an environment of a weakening global economy and that raises expectations that the US Reserve Bank will increase interest rates,” Richardson says.

“That’s not necessarily a sign of a weakening Australian economy, but more that the US economy is looking stronger. The European and Japanese economies are still weak so we’re expecting more demand for US denominated assets.”