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U.S. Economic Outlook: April 2016

Interest Rates Are Low, but Will Rise: Home Mortgage Rates Likely to Go Above 4 Percent Before Year End

Frank Nothaft    |    Videos

 

Interest rates have remained low for a considerable time in the U.S., and it is natural to wonder how much longer we may have such low rates. A partial answer came in mid-December when, after more than seven years of a near zero federal funds interest rate, the Federal Reserve raised its benchmark target by one-quarter of a percentage point.

Federal Funds Target

Federal Funds Target

In mid-March the Federal Reserve released an update of what the target funds rate should be, according to the committee members that set monetary policy (Exhibit 1). The update shows that most committee members expect, if the economy performs as they think it will, that the federal funds rate will be hiked an additional one-half of a percentage point later this year, probably in two quarter-point increments, and may be raised a full percentage point in both 2017 and 2018.

December’s hike in the federal funds target led many to expect that long-term interest rates would gradually move higher during 2016. Yet during the first two months of 2016, long-term interest rates dropped by about one-half of a percentage point. Why would long-term interest rates decline while short-term rates have gone up?

Long Term Interest Rates are Low

Long Term Interest Rates are Low

To understand why, keep in mind that the Federal Reserve can set the federal funds rate as part of its monetary policy. But the Federal Reserve has less direct control in determining the level of long-term interest rates, such as on 10-year U.S. Treasury bonds or 30-year fixed-rate home mortgages.

Long-term interest rates are affected by the expected rate of inflation over the investment horizon and by the level of real interest rates. If inflationary expectations decline, then long-term interest rates will also move lower because investors will require a lower nominal yield to earn the same expected return after inflation. Likewise, if weaker demand for funds or an increase in the supply of funds leads to lower real interest rates, then nominal interest rates will decline.

Long Term Rates

Long Term Rates

Since the beginning of this year, confidence in the U.S. economy, coupled with concern over lower global economic growth, has resulted in an increased supply of global funds investing in U.S. Treasury bonds, pushing real interest rates lower (Exhibit 2). Further, the relatively weak growth in the U.S. economy during the fourth quarter of 2015, which was estimated at the end of January at only 0.7 percent, may have reduced U.S. inflationary expectations somewhat.

These forces will likely be temporary, and long-term interest rates are expected to gradually move higher in the second half of 2016 (Exhibit 3). Thus, if you have been considering placing an application for a home mortgage loan, this is a good time to do so, as interest rates will likely be higher later this year.

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