"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?"