When Parsing the Banking Crisis, Don’t Forget Easy Money

Having presided over America’s first banking crisis since 2008, Federal Reserve officials are rightly focused on reforming regulation. That said, they should keep in mind some lessons for monetary policy, too.

The Fed has promised to complete a review of the recent rash of bank failures by May 1. No doubt, it will address issues such as the need for tougher oversight of mid-sized institutions, more proactive supervision, more diverse stress tests and greater scrutiny of how long-term investments are funded. It will probably remain silent, however, on the extent to which the Fed’s monetary stimulus and subsequent tightening might have contributed to the crisis. That’s unfortunate, because the topic deserves attention.

Consider the new monetary policy framework that the Fed introduced in 2020. The central bank committed to keeping interest rates near zero until the economy had already reached full employment and inflation had climbed above its 2% long-term target — meaning that the Fed would ultimately have to raise rates faster and higher than under its prior, more preemptive regime. This resulted in the largest interest-rate shock banks had seen since the 1980s: five percentage points in just 12 months.

Quantitative easing also played a role. When the Fed purchased trillions of dollars in Treasury and mortgage-backed securities to push down longer-term interest rates, it flooded the banking system with deposits, which banks often invested in the same longer-term securities at extremely low yields. This all but ensured that when the Fed later tightened, causing yields to rise and prices to fall, it would generate large mark-to-market losses at the banks.