What is clear from the first estimate of Q2 GDP was that the rise in imports which occurred as the dollar rose over the period did a huge amount of damage to the U.S. economy as the trade deficit widened.

Second quarter imports increased at a 28.8% annualized pace over the first quarter while exports increased by only 10.3%. Contrast this to the fourth quarter of 2009 after the dollar had weakened considerably from March of that year; By then, exports were increasing by 24.4% while imports grew by just 4.9%.

Now, I’m not claiming to make any big revelation here because depreciating the currency to boost exports is something that has been going on for centuries. But it is obvious at this point that with U.S. consumer spending constrained by a very weak job market, to say nothing of the balance sheet repair that is going on, the best avenue for growth in the U.S. economy at this time is via the export market.

Simply put, the Fed has to do all it can to murder the dollar.

Large amounts of job creation have historically been a result of 4 major factors:

1. War

2. Radical technological advances

3. Credit bubbles

4. Exports

To put it simply, choices 1, 2 and 3 are no longer available. War is now an economic drain (aside from being something that no one wants to see happen), there are no world-changing technological advances like autos or computers on the horizon, and we are not likely to have a credit bubble forming any time soon.

That leaves option 4 as the best chance for the U.S. economy at this time, given that fact that currency depreciation is not difficult to do and that millions upon millions of Asians figure to become more affluent consumers as time goes on.

So, it is now up to the Fed to do its job and depreciate the currency, which is what the recent talk about expanding its balance sheet is really all about. Remember, in order purchase assets the Fed has to get some cash and the way it does this is by pushing the “print” button on the electronic press. But there is another way to increase the supply as well; the Fed can to lower (or eliminate entirely) the interest it is paying to the commercial banks on the $1.2 trillion in reserves now being held by them at the Federal Reserve banks, reserves that were created during the ramping-up of Quantitative Easing.

Indeed, the question of why the Fed is paying interest now is one that has not been explained at all. Chairman Bernanke has said that a tool which the Fed could use to cool the economy (if and when that ever becomes necessary), would be to increase the rate it pays on reserves (or offer term deposits). So, if the Fed wants to expand economic activity at this time, which presumably it does, and paying interest on reserves is a tool it will use to slow the economy, then why is interest on reserves being paid now given the very weak state of the the job market and overall economy?

My personal guess is that paying interest on reserves is a way for the Fed to keep some of its powder dry. In other words, lowering the rate it pays on reserves is a tool the Fed has been planning to use to expand economic activity if and when it sees the need to do so. My thinking is that the time to use this tool is now. Here’s why:

First, it is evident that private sector job creation peaked in March and April and that the economy is set to slow further as the year progresses. The job of the Fed now is to manage the worst case scenario from the 2 risks it must deal with-inflation and deflation. While it can be debated whether the economy is truly heading towards deflation, it is apparent that it is now in a dis-inflationary period. But what cannot be debated is the fact that deflation is a much more insidious and difficult problem to deal with than inflation and that the greater risk to the economy, given the enormous amount of slack which now exists in aggregate demand and in the labor force, is coming more from the threat of deflation than inflation.

What it all comes down to is what the Fed says in its statement this week. While no one is expecting the Central Bank to announce any specific actions, investors will be looking to see if there has been additional discussion on the subject of re-starting Quantitative Easing and/or lowering or even eliminating the practice of paying interest on reserves. The market is getting nervous and it needs to see that Bernanke & Co. has its back.

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