It turns out that people are sensitive to prices after all.

At least some prices, anyway. On one level, it seems like that should be self-evident: after all, it’s a basic tenet of modern economics that when price of a given commodity rises the quantity demanded by consumers should fall. But the trouble is, it’s not always true – for example, egg prices spiked more than 150% in 2022, but it didn’t deter me from my two-egg omelet habit much at all.¹  

I suppose in some ways that’s just the nature of inflation: the less discretionary a purchase is (eggs are an almost daily staple and a key part of my morning routine,) and the smaller the overall spend (even when prices spiked at nearly $5 per dozen, my two daily eggs still only set me back $0.80 per day,) the less pronounced that effect is likely to be. We might grumble about how expensive things have become, or buy store-brand eggs instead of cage-free, but for the most part we simply go on paying those higher prices. Which, when all is said and done, is one way that inflation sinks its teeth in and sticks around for the long haul (and, at least in my case, is keeping my cholesterol levels elevated in the meanwhile.)

But when it’s a bigger-ticket item, we eventually start to balk at making that incremental purchase – especially if it’s something that we see as frivolous or luxurious. And that brings us to this week’s example of how things might finally be returning to some kind of normal as far as prices and inflation are concerned: AirBnB, that clever website that allows you to turn your unfinished basement into a Holiday Inn or empty guest room into a Travelodge, got clobbered last week as it reported estimate-beating earnings and guidance that were mostly in line with what analysts were expecting. What was its sin, you might ask? Executives dared to point out that they’re focusing on affordability and are a little bit worried about travel trends softening during the upcoming quarter when compared against last year’s stimulus-fueled travel splurge.²

Let’s be clear: there isn’t a whole lot of other evidence of a broader slowdown in travel just yet, and the stock prices of other travel related companies did just fine last week, making it seem as if AirBnB’s difficulties were more personal and limited in scope than a broad slowdown in travel might otherwise imply, at least as far as equity investors are concerned.  But on the other hand, it’s probably the first time you’ve heard the word “cautious” alongside “travel outlook” in a very long time, and if the logic about the relationship between prices and demand is sound, that’s probably a good thing because it suggests that consumers might finally be beginning to pull back in response to rising prices. When that kind of dynamic starts to show up in big-ticket discretionary items like travel, it seems like reasonably solid evidence that inflation might finally be on its way out. (Eggs, by the way, were down almost 11% in March according to last week’s CPI release...)

So the Fed has (maybe) finally beaten inflation. Hooray. But that always comes at a cost by way of falling consumer demand, which equates to slower economic activity overall (which, in turn, translates to recession if it becomes pronounced enough.) That is of course one of the primary questions markets are trying to answer for themselves right now: were the Fed’s rate-increasingly efforts “just right” (namely, precisely enough to cool inflation without tanking the economy,) or “too much” (successful at controlling inflation, but also severe enough to do real and lasting damage to consumer demand.)

The jury’s still out on that one. The lack of a big leg down in stocks, for example, probably suggests that at least some investors were happy to take Fed Chair Jerome Powell at his word twelve days ago when he claimed that it seems more and more likely to him that the US might actually be capable of enduring all of his rate increases without stumbling its way into recession. But while I’ll admit to being somewhat more open to that viewpoint than in the recent past, that optimism still feels at least a little bit Pollyannish to me, particularly with a debt ceiling debate rushing quickly to loggerheads and our own little mini-banking crisis still lurking in the background, potentially unresolved.

Besides, something else optimists may have missed (although Powell almost certainly did not,) is the Fed’s own Senior Loan Officer’s Opinion Survey, also released last week. That report, which provides all sorts of details how willing bankers are to extend loans to businesses and consumers, hits right at the heart of economic activity and is probably a far more important indicator of future economic growth than travel demand because it speaks to the life’s blood of a modern economy: credit creation.

And the news wasn’t necessarily great. The key takeaway seemed to be that lending standards are getting tighter and rates are rising across the board as banks gird for a weaker economy by reducing risk, a trend that appears set to continue for the remainder of 2023.³ (The increased reticence to extend credit was even more true at mid-sized banks, which drew special attention in this edition of the survey given turbulence in the regional banking sector.) At the same time, demand for loans of all types appears to be weakening as businesses and consumers react to higher rates and an increasingly anemic economy by borrowing less. The exception? Credit card lending, which has remained far more stable than demand for other types of consumer loans. Score one for the “economy is slowing its way toward recession” camp, I guess.

In many ways, this decline in borrowing is entirely understandable: raise rates high enough, and people stop taking out mortgage loans and buying expensive cars on credit. If interest rates are nothing more than the price of credit, then demand for loans can probably be viewed as every bit as price-sensitive as demand for travel (which is how we began this week’s Perspective in the first place.) So in that sense, its just another example of how prices and demand interact with one another, proving that at least in some cases, macroeconomic rules still apply.

Got it – people still care about price when making incremental buying decisions, including piling on more credit. But for their part, one thing markets seem to care less and less about these days is inflation itself. For example, last week’s CPI and PPI data were both reasonably good: inflation at the consumer level inched below 5% on a year-over-year basis for the first time in nearly two years, while producer prices dropped to 2.3% - also a two-year low and just a stone’s throw from that magic level of 2%.^4,5 In both cases, economists were pleasantly surprised by the data.

Not long ago, both releases would almost certainly have sparked a powerful (and sustained) rally in risk markets because they represent apparent progress in the Fed’s war on inflation. But last week, the market response was fleeting at best: on Wednesday, the post-CPI rally in stocks lasted about an hour before investors turned their attention to other things, while Thursday’s post-PPI “rally” was even shorter-lived. In both cases, the total daily move in stocks was utterly unremarkable. The market’s indifference to what should otherwise have been great news on the inflation front could be taken as a vote of confidence that inflation is truly on the wane, or it could simply be that the Fed gave us all permission to care about something else when it hinted strongly last week that it was about to hit “pause” its rate-raising campaign.

So pick your poison. But for me, the fact that markets are increasingly dropping their obsession with inflation and the Fed’s response to it feels like reasonably good news because it allows investors to re-calibrate and begin to focus on things that ultimately matter, like earnings and the economy. Let’s just hope they like what they find.

What to watch this week

Economic Events, May 15 – 19      

Monday: Empire State Mfgr., Fed speakers (x3)

Tuesday: Retail sales, NAHB builder sentiment, industrial production, Fed speakers (x3)

Wednesday: Housing starts/permits

Thursday: Philly Fed, Weekly jobless claims, existing home sales, leading economic indicators

Friday: Powell/Bernanke panel