Did the Fed cause the banking crisis?
This question could have several interpretations:
1. Did lax regulation from the Fed cause banks to take excessive risks?
2. Did the sharp increase in interest rates during 2022 cause the crisis?
Here I’ll focus on the second question, which itself is highly ambiguous:
1. Did a tight money policy at the Fed cause sharply higher interest rates, hurting bank balance sheets?
2. Did an easy money policy at the Fed cause sharply higher interest rates, hurting bank balance sheets?
In my view, the NeoFisherian model provides the best way of thinking about this issue—it was easy money that triggered the problem. Market interest rate movements have two components: changes in the natural (or equilibrium) interest rate and changes in the gap between the natural interest rate and the market interest rate. I’d estimate that roughly 90% of interest rate movements represent changes in the natural rate, and roughly 10% represent changes in the gap between the natural and market rate.
In 2021 and 2022, the Fed adopted a highly expansionary monetary policy, which led to wildly excessive NGDP growth. The fast NGDP growth pushed the natural interest rate much higher. In this sense, you could say that the Fed contributed to the higher interest rate environment that damaged bank balance sheets. The Fed raised its target rate by more than 400 basis points in 2022, and this mostly reflected an increase in the natural interest rate, which itself reflected faster NGDP growth caused by a previous easy money policy.
Once the Fed created the extremely rapid NGDP growth, they had few options other than sharply increasing the policy rate (fed funds futures target.) Some people suggest that the Fed raised rates too fast in 2022. But if they had raised rates more slowly, then inflation and NGDP growth would have accelerated even faster, the natural interest rate would have risen even higher, and the Fed would have eventually been forced into an even higher interest rate policy. The banking crisis would have been even worse.
Much of the discussion of this issue is marred by confusion, a lack of understanding of the distinction between changes in the natural interest rate and Fed actions that move the policy rate relative to the natural rate. Some people don’t seem to understand that the problem was excessive monetary stimulus, not excessively tight money. Thus the appropriate counterfactual was not to scale back 2022 rate increases from 400 to something like 200 basis points, the appropriate policy would have been to raise rates by 200 basis points in 2021, so that NGDP growth would have been much lower in 2021 and 2022, so that the Fed would not have had to raise rates so high in 2022.
In other words, if you always strive to have NGDP return to a 4% trend line, the natural interest rate will stay at much lower levels, and banks will have fewer problems with their balance sheets.
In theory, fast rising interest rates can be due to either the Fisher/Income effects (fast rising NGDP), or tight money (the policy rate rising relative to the natural rate.) It just so happens that in this case the rising interest rates were mostly due to fast growing NGDP, i.e. easy money. You don’t solve that problem by holding interest rates below equilibrium, just as you don’t solve the housing problem with rent ceilings.
When people blame the crisis on rising interest rates, they are reasoning from a price change. They need to be more specific. Was monetary policy too loose in 2022 or too tight? I say too loose. Yes, rising interest rates were a problem, but not in the way that most people assume. At a more basic level, it was the thing that caused the rising interest rates that was the real problem—easy money.
One other point: When I blame banking problems on unstable monetary policy, I am only discussing one factor. A well-run banking system (as in Canada) can survive NGDP instability. The US does not have a well-run banking system. In our system, NGDP instability creates periodic banking crises. We can fix the banking system or we can fix monetary policy. Why not fix both?
Mar 20 2023 at 8:51pm
Is this a trick question? The Fed raised the FFR repeatedly. Did it hurt bank balance sheets? Sure–the ones who hadn’t protect themselves from rate hikes.
As you wrote, yes, by fueling inflation in 2021.
It still wasn’t fast enough to stop inflation. I believe they’ve done as good as possible to achieve a soft landing. Last summer, many claimed the economy was at the brink of a recession.
Why does economic policy as pursued by the executive and legislative branches get so little blame?
Mar 20 2023 at 10:44pm
Banking regulations are part of the economic policy pursued by legislative and executive.
Mar 21 2023 at 1:37am
But the Fed has wide discretion as to how to implement the regulations.
Mar 21 2023 at 11:54am
Right, *part* of economic policy. As Powell has tried to explain to Elizabeth Warren over and over, the Fed’s tools are limited.
Mar 21 2023 at 9:58am
The “trick” is that, as you said, the Fed hiked, but it wasn’t tight money (expected to reduce inflation/NGDP growth) since they didn’t hike above the natural rate, which increased even more.
Mar 20 2023 at 9:48pm
The passenger bumped his head when the road turned sharply. Maybe the driver should have taken a different road but blaming her for not going over the cliff seems unhelpful.
Mar 21 2023 at 1:36am
That’s right, but the metaphor doesn’t quite capture the complexity of the situation. The Fed determines the path of the car, but also the shape of the road.
Mar 20 2023 at 11:16pm
Genuine question: But shouldn’t monetary easing lead to a one-off increase in NGDP? Why would we expect this effect to be sustained? I think my confusion stems from not understanding what you mean by the natural interest rate. In my mind, the Neo-Fisherian effect would be a temporay increase in nominal interest rates due to a one-time increase in the price level (aka inflation). Of course, this could also push up real interest rates if it heats up demand.In any case, once the monetary stimulus subsides, shouldn’t the natural interest rates go back to where they were?
Mar 21 2023 at 2:14pm
The monetary stimulus continued through 2022. Rates were persistently held below the natural rate.
Mar 21 2023 at 2:38am
One tricky part, to me, is that much of the practical issue regarding duration risk at the banks has been an increase in real long term rates. This appears to be related to a loose policy posture coming out of covid. But since it is a rise in real rates and not a rise in the inflation premium, it seems possible to me that, whatever complaint one might have about the short term inflation fluctuations, that there has been an improvement in real long term growth expectations and investor risk aversion. All in all, that seems like a potential net positive.
I don’t know. What do you think?
Mar 21 2023 at 6:58am
Bankers who lived through the 80’s and 90’s are probably smart enough to see that the Fed is trying to stabilize things, but it will require a period where interest rates are stable in the 3% to 4% range. The SVB crowd didn’t seem to have enough gray haired bankers who could conceive of an environment where the Fed ever had to push the rate above 2%.
If we have a decade that resembles the 90’s then I agree that things will be a net positive. Scott may grumble about an NGDP rate that frequently drifts above 5% but that would be more sustainable than the last two years.
Mar 21 2023 at 12:00pm
That”s an intriguing question. Do higher long-term real rates indicate an improvement in long-term real growth expectations? My guess is that it was more a consequence of tighter money and uncertainty.
By improvement in risk aversion, are you referring to less inflation uncertainty?
Mar 21 2023 at 8:08pm
I’m just inferring that higher long term real risk free interest rates mean that investors are more inclined for at-risk investments, and so yields for risk free savings aren’t being bid as low.
Mar 21 2023 at 2:15pm
Possibly, but it could also reflect our worsening long run budget situation. I’m skeptical of the claim that growth prospects look good.
Mar 21 2023 at 7:16am
There’s credit risk, and then there’s interest rate risk. There’s a regulatory incentive to hold governments.
You can’t boil it down to anything simpler. N-gDp is still too high. It is estimated at 9% in the 1st qtr. of 2023.
AD = M*Vt, where N-gDp is a subset and proxy. The FED controls AD. But Powell and Selgin think banks are intermediaries. Bank credit contraction reduces the money supply. Not so with the intermediaries.
Interest rate manipulation as a monetary transmission mechanism is non sequitur. Interest is the price of credit. The price of money is the reciprocal of the price level.
The FED is doing things backwards. You drop interest rates and drain reserves at the same time. I.e., by driving the banks out of the savings business, you increase the supply of loanable funds, but not the supply of money.The correct response to stagflation is the 1966 Interest Rate Adjustment Act.“while the aggregate of time and demand deposits continued to increase after July, the proportion of time to demand deposits diminished. Whereas time deposits were 105 percent of demand deposits in July, by the end of the year, the proportion had fallen to 98 percent. These were all desirable developments.”M1 peaked @137.2 on 1/1/1966 and didn’t exceed that # until 9/1/1967. Deposit rates of banks, Reg. Q ceilings, decreased from a high range of 5 1/2 to a low range of 4 % (albeit not enough). A .75% interest rate differential was given to the nonbanks.And during this period, the unemployment rate and inflation rates fell. And real interest rates rose.
Mar 21 2023 at 8:13am
A universal guarantee on all bank deposits, like during the GFC, will reduce the supply of loan funds, will reduce the transaction’s velocity of funds, will reduce the real rate of interest, and thus will lower R-gDp and raise the Federal Deficit.
The FED’s Ph.Ds. don’t know a debit from a credit, a bank from a nonbank.
Mar 21 2023 at 9:43am
Powell is dangerous. Powell doesn’t know what he’s doing. With the Continental Illinois bailout, reserves were “washed out”.
Mar 22 2023 at 7:41pm
Can you elaborate on how moral hazard is being added to the system? Here’s how I see the absurd situation we currently have with fractional reserve banking:
You are a depositor. If you’re a business or semi-wealthy person, you need to either read a 300-page 10-K and analyze every footnote to determine how risky your bank is, OR spread your deposits among dozens/hundreds of different banks with a sophisticated cash management system to stay below the $250k limit per bank, OR have a sophisticated system utilizing extremely low-duration money market funds in a brokerage account with low/no counterparty risk
If you don’t do (1) and your bank fails, you are somehow being ‘immoral’ for not recognizing the risks it took and should lose some or all of your money. Your deposit being made whole (while shareholders and bondholders are wiped out) somehow incentivizes risk-taking on the part of other banks. After all, according to this view, you are not just a depositor keeping your money in a vault – you are a creditor (earning 0%) who ensures banks maintain discipline, and you’d better know the operations of any bank inside and out before you deposit with them!
Unless, of course, you move your assets to a GSIB. A GSIB will *always* be bailed out, no matter how high above the FDIC limit your deposits are. People are waking up to this, and thus we see massive capital flight from regional banks. Barney Frank had an interesting interview a few days ago where he discussed trying to raise the FDIC limit in 2008 but being stymied by GSIB political lobbying, who understood the game theory here and how it benefits them.
I view the above system as absurd and unfair – there’s a kind of LARP that banks are free market institutions, when in fact they’re already heavily socialized, and confusion over this fact seems to spur much of the debate over the recent “bailouts.”
This doesn’t even address the market distorting effects of mortgage and student lending enabled by fractional reserve banking, which arguably push home and education prices far above their natural equilibrium levels with questionable social/economic utility.
What are your thoughts?
Mar 25 2023 at 10:04am
Jonathan: I can share my thoughts:
if you are “a business” – especially a startup – you have a financial team that understands and manages financial riskes. What is the CFO doing if not minding the money? Silicon Valley businesses, especially, have plenty of access to financial expertise. However, if your CFO’s plate is too full to mind the cash, then s/he can delegate protection of the cash by buying insurance for the deposit. Simple.
If you are a “semi-wealthy person”, where’s the danger? My bet is that most people that have more than a million or so in cash lying around also have financial advisors. Some people I know that have a $500K homes (not very expensive where I live) and worked as public school teachers have financial advisors. So I don’t see the danger. However, again, the short cut is that rather than managing six different accounts, just purchase insurance if you have more cash than public deposit insurance covers.
OK, it’s doable for the public to just insure everything, but why should it? Why should the general public carry the cost of insurance for wealthy individuals and companies? The people who need the insurance should pay for it.
Mar 22 2023 at 9:14pm
What is the duration of the natural rate of interest hypothesized to be? Overnight, 3 months, 2 years, 5 years, 10 years, 30 years? I suppose there could be a natural rate of interest for every term.
Scott, what economic model do you have in mind when you say that the natural rate changes when monetary policy is not appropriate?
Grand Rapids Mike
Mar 23 2023 at 1:43pm
What I don’t understand is why no discussion of the massive M2 increase from March 2020 to December 2022. This would seem to be a cause inflation worth some discussion, does anyone remember Milton Friedman.
Mar 23 2023 at 4:16pm
The fed reduced interest rates to zero that’s allowing the government to borrow trillions at will. Banks like SVB bought supposedly secure long-term AAA government securities to back up short-term deposits. When the fed raised interest rates, the so-called safe securities, like all long-term bonds, dropped in value and became toxic. SVB’s accounting “held held to maturity” masked the accruing losses, which only became evident when deposits went out the door and they had to sell this toxic mess.
Yes, the Fed was a responsible, though SVB made poor risk management decisions. Other entities are also holding this toxic crap: there’s more pain to come.
Mar 25 2023 at 12:44am
“Banks like SVB bought supposedly secure long-term AAA government securities ”
Those securities are still secure. A “secure” bond means that the issuer will not default on the payments. It doesn’t mean that there is no price risk on the bond. It’s the payment that is secure, not the value. Bankers know this.
SVB was well aware that it’s portfolio was under water. My understanding is that they discussed the situation on their Q322 & Q422 conference calls. The public, however, was not aware. When they suddenly became aware they pulled their money and triggered the collapse of the bank.
SVB is entirely responsible. The Fed could and should have managed the situation better, but SVB understood or should have understood the risk it took. Even though some other banks are in trouble, most banks remain sound, because they didn’t make the mistakes that SVB made.
Mar 24 2023 at 7:24pm
Jeremy Siegel talks to Wharton about the impressive failures of regulators and the Fed as to the recent banking problems, and interest rate policy from here….
Mar 25 2023 at 12:31am
I’m not clear on what you mean by “easy money” – by that you mean a significant gap between the policy rate and the natural rate?
So had they not allowed “easy money” in 2021 – that is, a significant gap to develop between the policy rate and the natural rate – rates would be lower now because they would have slowed growth before it got to hot. That, in turn, would mean banks would have less losses now and the whole situation would have been avoided.
So why did they allow easy money then? My understanding was to grease the economic wheels during the pandemic, no? But I think they kind of got themselves in a bind by saying they would hold rates at zero for an extended period.
For my taste Powell guides with too much certainty too far into the future, putting himself in a corner down the road when things change in unexpected ways, which they always do.
Mar 27 2023 at 2:09pm
Seems like there is an argument being made here that banks are unable handle changes in interest rates. They have no agency and everything bad that happens is the fault of everyone else, the government, regulators, media and anyone else you can think of.
Apr 13 2023 at 7:40am
Interest rates were kept too low for far too long, facilitating a huge expansion of the money supply, aka inflation. Prices will react after a period of lag. If you raise interest rates and stop the monetary expansion prices will eventually stabilize, but at a higher level than they were before.
Sort of like the deficit versus debt conundrum.
Increase in reserve requirement would also slow down money supply expansion. Can someone explain why this is not preferable to interest rate increases?
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