Thirty-year mortgage rates eased downward throughout much of 2014. Can this trend continue in 2015? And what about savings account rates and other deposit rates -- will they remain mired near zero, or will they finally show signs of life?
Following the economic factors that influence interest rates is like watching a wide-ranging drama with a great many characters. In 2013, the character at the center of attention was the Federal Reserve. This year, the most compelling character in the interest rate drama has been oil.
Oil prices have been instrumental in helping mortgage rates fall this year, but watch out -- oil is a slippery character that could just as easily push rates higher next year.
The influence of oil on interest rates
Inflation has remained unusually low in 2014, and oil prices are a big reason why. After peaking around midyear, the price of a barrel of oil has since fallen by about 40 percent. This in turn has pulled down inflation overall, with a year-over-year increase of just 1.7 percent for the CPI as of October. Without energy, that inflation rate would have been 2.0 percent, and if oil prices were rising rather than falling, it would be even higher.
This is crucial to interest rates. On the long-term end, mortgage lenders demand an interest rate premium over the inflation rate. Interestingly, since the early 1970s the typical rate premium has almost exactly matched the average inflation rate itself, at around 4.3 percent. Put a 4.3 percent premium on top of a 4.3 percent inflation rate, and you get the 8.6 percent long-term average of 30-year mortgage rates. By the same logic, if inflation were to rise to 2.5 percent, it would not be surprising to see mortgage rates head toward 5 percent.
In recent years, persistently low inflation has led the Fed to keep short rates near zero. If more normal inflation were to establish itself, the Fed would eventually feel comfortable with raising short rates rise.
The question is, will inflation re-establish itself? Again, that largely comes back to the price of oil.
A slowing global economy and the emergence of fracking as an important marginal source of oil have been instrumental in the plunge in oil prices. However, markets tend to be far-sighted enough to look beyond economic cycles, so the oil price reaction to the global slowdown should not be too extreme. Plus, strength in the U.S. economy is an important counterweight to generally weaker conditions elsewhere. Historically, a strong U.S. economy has helped pull the world through slow patches.
As for the influence of fracking, the price of oil is getting down to the cost of production of the typical fracking operation. That could well create a floor under oil prices at somewhere near the current levels.
The bottom line on the influence of oil: Unless you expect another 40 percent drop in the price of oil, don't expect inflation to be as mild in 2015 as it has been in 2014.
Oil may be the central character in this drama, but there are other actors that could play an important role in the direction of inflation and bank rates over the next year:
- Wage pressures. 2014 has been a terrific year for job growth, and as some of the slack in the job market gets taken up, employees should have more bargaining power. Wages have been a benign factor in recent years, but as employment tightens, they could start to exert more influence on inflation.
- Default rates. Default rates for mortgage loans and other forms of consumer debt have been rising, which could lead nervous lenders to demand higher rates to protect themselves.
- Loan volume. Consumers have also been borrowing more of late, and this added demand is another factor that could drive interest rates higher.
Outlook for long and short rates
Where does this leave the outlook for interest rates? Return to the notion of oil being the central character in this drama. If oil prices just level off, the inflation rate should start to rise, and if oil prices bounce back -- even partially -- toward previous levels, the rise in inflation could accelerate.
This could easily put the inflation rate between 2 and 3 percent next year. This would put two things in motion. Lenders would start to demand a more normal premium over inflation -- or at least one that matches the prevailing inflation rate itself. Also, the Fed could finally feel confident enough in the economy to raise short-term rates.
Of these two developments, expect lenders to react more quickly. The Fed is likely to wait until higher inflation is well established before finally raising rates. What this means is that 30-year mortgage rates could be well into the 4 to 5 percent range by mid-2015. As for savings account rates and other bank yields, the journey higher is likely to be much slower.