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The Federal Reserve has aggressively increased interest rates to combat inflation. Elevated rates make borrowing more expensive, directly curbing lending activities. Additionally, the Fed has been reducing its balance sheet by selling off treasuries and mortgage-backed securities, which further shrinks the funds circulating within the banking system.
2. Decrease in Bank Deposits
As the Fed reduces its holdings, banks experience a decline in their deposit base. According to Goldman Sachs research, banks have responded by raising large time deposits, selling financial assets, and reducing the volume of loans extended. Evidence of this is visible through the correlation between rising federal funds rates and declining bank deposits.