What's in Store for Interest Rates

If you think the tiny bump up in interest rates over the last week was bad, wait till you see rates a year from now.

No one can predict the future, of course, but there's good reason to think that average interest rates for 30-year home loans will be well above 5 percent or even 6 percent by the end of 2010.

The average interest rate for a 30-year home fixed-rate mortgage climbed to 4.94 percent, according to the Freddie Mac's Primary Mortgage Market Survey, released December 17. That's up from a historic low of 4.71 percent two weeks ago.

Average interest rates are under five percent for a number of reasons that can't last.First, the Federal Reserve has set its overnight "federal funds" interest rate at effectively zero since the credit crisis last year. Just for some perspective, in 2003 and 2004 officials cut the Fed Funds rate to 1 percent. At the time, it seemed incredibly low. Any change in the Fed Funds rates tends to have a massive ripple effect through the rest of the economy.

The Fed Funds rate is usually kept higher to fight off inflation. And yes, inflation can happen even in a stagnant economy. In the 1970s, they called it "stagflation." Fortunately, inflation is still well under 2 percent a year, according to the latest Consumer Price Index.

Fed officials don't plan to raise the Fed Funds rate immediately, according to a statement from its meeting December 16. They say the weak economy is "likely to warrant exceptionally low levels of the federal funds rate for an extended period." But that 'extended period' is unlikely to last for another full year. In fact, it's likely to end at the first serious hint of inflation.
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