Fed Chair Janet Yellen claimed in her press conference Wednesday that unexpectedly low inflation numbers were due to one-off reductions in particular commodities, such as pharmaceuticals and mobile phone services. Inflation, she continued, ought to pick up until it meets the Federal Reserve’s 2% target. Year-on-year change in the core Consumer Price Index (excluding food and energy) printed today at 1.7%, vs. a consensus estimate of 1.9%. “It’s important not to focus on a few readings,” Yellen added, particularly because the undershoot was due to “idiosyncratic” factors.

Yellen is wrong, arithmetically and conceptually.

Moderation of shelter inflation
Source: Bloomberg

US inflation is moderating mainly because the single biggest component in the index, namely shelter, is growing more slowly than it has during the past several years of housing price recovery. Shelter is one-third of the Consumer Price Index (and an even larger portion of core CPI). Very rapid increases in home prices during the recovery following the 2008-2009 housing price crash buoyed the inflation numbers during the past several years. Now that home prices have reached their previous peak, the rate of price change has slowed. As a matter of arithmetic, that is the single largest reason for inflation to slow.

The Fed’s measure of owner-equivalent rent inflation generally tracks the Shiller-Case Home Price Index with lags of up to 12 months.

Owner-equivalent rent inflation vs change in home prices
Source: Bloomberg

Rising home prices caused the shelter component of the inflation index to rise much faster than the overall index, to a peak of 3.5% year on year in April 2017. The outsized contribution from home prices masked weakness in other sectors.

Now this is coming to an end. A simple model that forecasts changes in shelter inflation from lagged values of home prices (over 12 months) suggests that the inflation rate for shelter will fall from its 3.5% to peak to 2.7% by the end of 2017. That’s a fall of 0.8% in shelter inflation, and it translates into a reduction in the overall core inflation rate of about 0.32%. That may not seem like a lot, but the difference between 2% and 1.7% is enough to change Fed policy.

Shelter inflation, actual and forecast from home prices
Source: Bloomberg

Chairman Yellen’s argument that “idiosyncratic” events are to blame for the failure of the Fed’s inflation forecast doesn’t square with the home price effect, which clearly is a change in a trend rather than a one-off oddity. Other important prices, moreover, are weak for reasons that hardly can be called idiosyncratic. Automobile prices constitute about 5.7% of the overall CPI (and an even large percentage of core CPI). They fell by 0.2% in May, probably because credit problems among lower-income consumers are restraining car sales.

The economy simply is weaker than the Fed thinks it is, or wants to admit it is.