The forty basis point jump in long term credit rates, including mortgages, from early May to early June has now been reversed. But we should not forget the immediate impact this had on mortgage applications and bank lending volume, including commercial mortgages.  This was a preview of what will happen when the credit constrain becomes binding sometime next year.

The quick spike in credit rates, premature as it turns out, was possible because lenders are nervous about the adequacy of credit when the recent drop in GDP is largely reversed.  Lenders are also, for the first time, especially concerned about the ability of the US to attract credit in competition with other countries in a constrained market.

The prospective credit constrain has two components which you should watch separately.  These are the normal rise in rates during an economic recovery and the possible extra rise in rates from the rapid growth in federal government borrowing for new programs.
The consensus economic outlook expects the normal rise in rates to come sooner after a turn to recovery than usually occurs.  This results from the loss of available credit from the combination of financial de-leveraging, some legally required and some just prudent lending, and the loss of lenders assets when loans were not repaid.

Typically, this constraint would not be binding until GDP was clearly above its previous peak level.  In this recovery that would be no sooner than early 2011. But with available credit reduced, it could be as much as a year soon.  This is the point at which more expensive credit is clear to everyone but as much as two years before the credit constraint is serious enough to force a halt in spending growth.

The second component of the coming credit constraint has a much fuzzier timing and magnitude. This is the increase in borrowing for additional federal spending.  However big and whenever it happens, this will raise credit rates for all borrowers. And there is also a risk that it could raise rates to all US borrowers if foreign lenders remain concerned that the federal government has borrowed more than it can repay without depreciating the $US with inflation.

How much extra the new team in Washington will borrow is still unclear.  They have pledged to boost the 2010 spending budget by nearly a $T.  Both the pending healthcare and cap and trade (carbon tax) proposals may add a large share of an additional $T in the next few years. Also, most of the $787 B stimulus plan spending has yet to be borrowed. The federal housing finance agencies are on track to borrow over a $T in the next few years to forgive mortgage payments. Financing the auto industry may cost several hundred billion.  And the Federal Reserve Board will soon be desperate to withdraw the $T dollars of added credit that it has provided on an emergency basis.

Add it up.  This is enough money to be a huge problem for the economy. As always, this scenario will play out with inflation (and rising credit cost) that permits the economic expansion to continue on the false premise that everything is fine. This could persist into 2011 yielding to an abrupt end to expansion.  Or we could take out medicine in small doses by boosting credit costs relative to inflation and slowing the pace of economic growth to below normal.  Which path to take may well be hotly debated before the 2010 election.

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