Why Interest Rates are Going to Rise

For the past two years, the nation’s top economists have repeatedly predicted that interest rates would rise, and we would see an end to historically low rates.  Instead, rates have fallen to record new lows.

Why are leading housing economists like Sean Becketti of Freddie Mac, Mike Fratantoni of the Mortgage Bankers Association and NAR’s Lawrence Yun still worried about rates on the long term?  Though Becketti has lowered estimates to 3.9 percent by the end of this year, he still expects rates on a 30-year fixed to hit 4.5 percent in 2017.[1]  Fratantoni sees rates reaching 4.8 percent in the fourth quarter of next year.[2]  Yun is also forecasting mortgage rates to end this year at 3.9 percent—about where they were at the end of last year—but will rise to 4.6 percent in 2017.[3]

Many events, ranging from international financial instability to domestic mortgage demand, contribute to changes in mortgage rates.  The most important factor is the Federal Funds Rate, set by the Federal Reserve’s Open Market Committee at its six meetings a year.

Even after the Federal Reserve raised rates last December for the first time since 2006, instead of rising, rates on a 30-year fixed rate mortgage fell to 3.58 percent by May 21, the lowest level in three years.  At its April meeting, the Fed took no action, but conditions are changing.

Why will rates rise in the months to come?  The answer can be summed up in one word: inflation.

Nothing sucks the wind out of an economic recovery like inflation, which is one reason the Federal Reserve monitors it closely.  The Fed has an annual inflation target a rate of 2 percent per year; should inflation rise above that level, expect the Federal research to raise rates more than they did in December.  The most important factor driving inflation is oil prices.

At NAR’s Midyear Meeting, Yun said today’s low consumer price index (CPI), at about 1.7 percent, doesn’t reflect the rise in prices people see on everyday items because low gas prices have been keeping the broader index down.[4]  Excess supply kept oil prices low beginning in 2012[5] and contributed to the Fed’s decision not to raise rates.

Early this year, conditions changed. Gasoline prices shot up 8.1% in April.  Even with all food and energy items removed from the index the CPI, has increased 2.1% year over.  Low prices stimulated demand and world oil prices rebounded from a low of $25 per barrel in mid-January to $40 per barrel in April.[6]

Driven by the politics of OPEC as much as the forces of supply and demand, oil production is difficult to predict, but demand will keep prices rising.  Oil price inflation is expected to continue. In early May, the US Energy Information Administration upped its forecast for the average price of crude in 2016 by $6 a barrel, from its April estimates of $34.73 per barrel to around $40.52.[7]

How will the Federal Reserve react when it meets in June?

It answered that question at its April meeting: “Inflation is expected to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate, and the labor market strengthens further…The (Federal Open Market) Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”[8]

That’s why the smart money expects rates to continue to rise, gradually at first, faster in the years to come.