Former regulator warns Fed fueling bond bubble

One of the nation's former top financial regulators is warning the Federal Reserve is concocting a "toxic brew" with its monetary policy.

Sheila Bair, who headed the Federal Deposit Insurance Corporation (FDIC) until July, wrote Monday that the near-zero interest rate policies of the Fed could be fueling the next big bond bubble, and called on it to begin boosting rates as the economy slowly recovers.

"The Fed's actions have kept Treasury bond prices high (while keeping the government's interest costs low), but the fundamentals do not support the high valuations, given the fiscal mess we are in," she wrote in a column published by Fortune. "Sooner or later, the bond bubble will burst."

Bair was appointed to head the FDIC by former President George W. Bush, and in her piece she sets her scrutinizing sights on the regulator run by a fellow Bush appointee, Fed Chairman Ben Bernanke. Bair left the FDIC after her five-year term expired.

In particular, she blasted the Fed for allowing the government to borrow money at bottom-dwelling rates, arguing the move lets Congress pass the buck on serious fiscal discipline.

"As long as Treasury can borrow cheaply to paper over the real problems, politicians can demagogue about overspending (GOP) or undertaxing (Democrats) while dodging their responsibility to work together to fix our problems," she wrote.

The Fed has kept interest rates near zero since 2008, after the last housing-driven bubble burst. And Fed officials have indicated that they expect those low rates will stick around until the end of 2014, as the economy slowly recovers from the last crisis.

But Bair argued that while the market for U.S. government debt remains robust, that should not be confused with a strong economic position. Rather, she contended that foreign buyers continue to turn to Treasury bonds because similar debt sold by European nations looks far less appetizing right now, amid the continent's debt crisis.

"In short, we are the best-looking horse in the glue factory," she wrote.

With the economy having recovered somewhat, Bair contended it was time for the Fed to "declare victory" and allow the market to begin pushing rates upwards.

"Start deflating the bubble before it pops," she said.

At the very least, an upward swing in interest rates could serve as the "wake-up call" sorely needed by Congress and the White House to get serious about getting the nation's books in order.

— This story was updated at 3:44 p.m. to reflect that the column was published by Fortune.

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