Why do the wolves in Wolf's Rain look human?

This is the most misunderstood device in the series, so here is the plain version first: the wolves never turn into humans. Wolves in this world survived their supposed extinction, nearly two hundred years before the story, by casting illusions over themselves. A wolf walks through Freeze City on four legs, and every human who looks at it perceives a young man instead. The audience is shown both, which is why scenes cut between the two shapes.

The device does real narrative work. It explains how the pack can hide in cities, work, eat, and be hunted by men who shoot at what they think is a person. It also sets up the series' recurring heartbreak: almost no human ever sees a wolf as a wolf. Quent Yaiden, the hunter, is terrifying partly because he is one of the few who half suspects the truth. And it means the wolves' whole lives are spent being misread, which is the emotional condition of the entire show.