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FDIC Chair Sheila Bair spoke with Bloomberg News Tuesday and the topic was interest rates and banks ability to withstand a higher interest rate environment. While Bair was careful to stress that this is not a "short-term problem," she indicated that as a bank regulatory supervisor she requests banks determine the stress on their balance sheets of higher rates. She said "the banking system is healing." So she believes we are on the road to recovery as far as her domain of expertise is concerned.

In the discussion, she also talked about fiscal policy and the need to rollover 55% of maturing Treasury debt in the next three years. Her view is that this presents a ‘fiscal problem’ which makes preparation for higher interest rates important. It is interesting that she is the second monetary regulator to talk about fiscal policy in the last few days, suggesting that the US has to rein in deficits. She knows austerity is a loaded word, but suggests that the US take measures to reduce the deficit over time or at least put a plan in place. Ben Bernanke made similar comments earlier this week (see here).

The problem with her argument is that deficits are an ex-post accounting identity that are largely the result of changes in the real economy and non-discretionary spending. The only way to deal with the deficit is to move to full employment and/or cut military spending and entitlement programs. Concentrating on the causes of deficits is more likely to restore fiscal health than concentrating on the deficit itself per se. Moreover, interest rates are unlikely to spike unless we see a measured increase in sustained consumer price inflation, which is unlikely until the output gap closes; again full employment is key here.

In my view, it is curious that monetary regulators are discussing fiscal policy, which is clearly outside of their purview. Bair recognizes this and declined to talk about specific austerity measures she would support.

Source: Bair: Banks Must Prepare for Higher Rates