The table at the right summarizes the percent change between January 6 and November 11 in the cash prices of 19 commodities reported in the Wall Street Journal (downloaded via Webstract). The average commodity in this list has appreciated 37% since the start of the year.

A recent paper by Ke Tang and Wei Xiong documents an increasing tendency for commodity prices to move together over the last few years. A decade ago, what happened to oil prices was largely unrelated to movements in most other commodity prices. The graphs below show how the correlations between oil prices and the prices of four representative commodities have increased significantly over time.

Correlation (using a rolling sample beginning one year before indicated date) between returns on oil and specified commodity. Source: Tang and Xiong (2009).

One explanation I often see in the popular press is that movements in commodity prices are driven by changes in the value of the dollar relative to other currencies. However, the magnitude of movements in commodity prices greatly exceeds the size of changes in the exchange rate. For example, the table above shows that since the start of this year oil prices have increased five times as much as the dollar price of a euro; see also Steve Gordon's graphs. While the depreciation of the dollar is part of the story, most of the explanation must be found elsewhere.

Another important factor is resurging real economic growth outside the United States, which produces pressures for both the dollar to depreciate and the real price of commodities to appreciate. According to this theory, the increasing correlations between commodity prices results from the fact that countries like China are so much more important for the world economy today than they were a decade ago.

A third explanation is that investors are making increasing use of commodities as an investment class. Although Treasury Inflation Protected Securities offer a hedge against an increase in the U.S. consumer price index, they don't offer protection for foreign investors against depreciation of the dollar. Insofar as increases in the prices of commodities like oil may depress real economic activity, holding commodities as an investment also offers useful diversification against risks to equities. Particularly when interest rates are low, there is an incentive to hoard physical commodities as an investment vehicle.

The paper by Tang and Xiong proposes that the increased use of commodities as a financial investment accounts for the increasing correlation among commodity price changes over time. In support of that claim, they note the growing popularity of investment strategies based on the Goldman Sachs Commodity Index or the Dow Jones Commodity Index. Tang and Xiong document that correlations among commodities included in the indexes have increased faster than those not included. For example, one of the regressions they estimate relates the return on commodity i to equity returns, bond yields, the value of the dollar, and oil prices, where the coefficients are allowed to grow with time at different rates before and after 2004, and with different trends on these coefficients estimated for commodities included in indexes as for those excluded. The figure below shows their estimated time path for the coefficient on oil prices comparing the indexed and non-indexed groups.

Coefficient relating return on average commodity to return on oil as a function of time for commodities included in the GS or DJ indexes (top curve) and those excluded (bottom curve). Source: Tang and Xiong (2009).

For any of the explanations in this third class, one of the important challenges is to reconcile the story of commodity speculation with supply and demand for the underlying physical commodity. If we propose that speculators have driven the price of the commodity up, the physical quantity demanded should decline as a result. In order to be sustained, a coherent speculation-based theory of commodity price appreciation requires increased physical storage of the commodity.

The solid black curve in the figure below plots the typical U.S. crude oil stocks (excluding those held in the Strategic Petroleum Reserve) for each week of the year, based on the average over 1990-2007. The red line gives the actual values for 2008, which were significantly below the historical average, particularly in the spring of 2008 when oil prices were rising so dramatically. Those below-normal inventories were one reason I focused on what was going on to the fundamentals of supply and demand in trying to understand the behavior of oil markets in the first half of 2008.

Weekly U.S. crude oil ending stocks, excluding SPR, in thousands of barrels, from EIA. Black line: average over 1990-2007. Red: 2008. Green: 2009.

On the other hand, inventories of crude oil this year, shown in green above, have been substantially above normal, meaning that in the absence of that oil going into storage, we would have expected to see lower oil prices than we currently have.

Moreover, much of the current stockpiling may be taking place outside the United States. For example, Yves Smith noted this story from Bloomberg last August:

Copper, nickel and other base metals stockpiled by speculative Chinese investors including pig farmers may be sold when "market sentiment turns," said Scotia Capital Inc.

A price surge and easy bank credit this year encouraged pig farmers, stock brokers and businessmen to buy copper and nickel for speculation, Liu Na, an analyst with Scotia Capital, wrote in a note dated Aug. 17, citing reports from the state-owned China Central Television....

"These stockpiles are in 'weak hands' as speculators have no real use for base metals," Liu wrote. "When the market sentiment turns, they are very likely to turn into quick sellers, especially when the bank's money is involved."

I also found this November 3 story from the Financial Times of interest:

Gold prices continued to rise on Wednesday extending the all-time highs which followed India's central bank bought 200 tonnes of the precious metal, swapping dollars for bullion as the country's finance minister warned the economies of the US and Europe had "collapsed".

India's decision to exchange $6.7bn for gold equivalent to 8 per cent of world annual mine production sent the strongest signal yet that Asian countries were moving away from the US currency.

Policy-makers in the Federal Reserve have traditionally thought of inflation as a broad movement in all wages and prices, which to some extent is under their control, and viewed changes in relative commodity prices as outside their control. I believe that this is not the correct understanding of the current situation. Concerns about inflation, particularly on the part of foreign dollar-holders, are likely to show up first in the relative prices of internationally traded commodities. Insofar as these relative price changes can be destabilizing in themselves, it cannot be wise for U.S. policy-makers to ignore them.

Deutsche Boerse and SIX Swiss Exchange have announced that they are buying out Dow Jones’ one-third stake in Stoxx for a consideration of 206.1 million euros, or $306 million.

Following the transaction’s completion, which is due to take place early next year, Deutsche Boerse will have a controlling stake in Stoxx of 50 percent plus one share and will fully consolidate it for accounting purposes.

In addition, SIX and Deutsche Boerse will set up a new entity to perform index calculations, in which SIX will own 50 percent plus one share.

According to a Stoxx press release, the transaction will allow both Deutsche Boerse and SIX to significantly expand their positions in the international index business, complementing their established DAX and SMI index families.

The sale could be a precursor to the long-rumored sale of Dow Jones Indexes. The Wall Street Journal reported in August that News Corp. was considering selling the venerable index provider, which has annual revenues of approximately $130 million to $170 million.

ExxonMobil (XOM) has been producing a little over 2.4 million barrels of oil a day for the last year and a half, its lowest rate of production over the last decade. The dark blue line in the figure below shows the company's production each year since 1999. Four years ago, Stuart Staniford noted that ExxonMobil's 2001 annual report predicted 3% annual growth in production between 2001 and 2007. That projection appears as the red line in the graph below; didn't quite come out as planned. Stuart's theory was that the company correctly predicted the contribution of its new discoveries, but underestimated the declining production rates from mature fields.

ExxonMobil again predicted in 2006 that it could achieve 3% annual growth over 2006-2011. I've shown that forecast as the lighter blue line in the figure. We still have two more years to make that one right, I suppose.

Dark blue: ExxonMobil's annual net production of crude oil and natural gas liquids in millions of barrels per day. 1999-2008 from company's annual reports. 2009 based on average of 2009:Q1 and 2009:Q2. Red: forecast from the company's 2001 annual report. Light blue: forecast from the company's statements in 2006.

The Wall Street Journal reported on Wednesday that ExxonMobil is prepared to spend $4 billion to buy 1/4 interest in the Jubilee oil field off the coast of Ghana, which would represent 15% of the oil giant's 2008 capital and exploration budget. Alan von Altendorf thinks they can't make a good return unless they sell the oil for $100/barrel. Presumably the company is reckoning on more oil in the field than current estimates suggest. But even if von Altendorf's calculations are off by a factor of two, it still seems to signal a change in philosophy for a company that has historically been extremely careful with its investments in order to maintain its position as a very low-cost producer.

But what else is the company to do? It's not like they haven't tried to take advantage of Russia's or Venezuela's strong commitment to protect foreign investors or the peaceful aspirations of Nigerian rebels.

Chevron (CVX) and many other companies are finding clever new ways to get more oil out of mature U.S. fields. That may well succeed in slowing the rate at which production from those fields declines over time. But to get the plot in the graph above to slope up you really need to develop new fields.

The New York Times is encouraged by the "brisk pace of new discoveries" which the paper reports "have totaled about 10 billion barrels in the first half of the year".

The Oil Drum, always a party pooper, notes that the world likely consumed that much in the first four months of the year.

Investors are increasingly favoring bonds over stocks, according to a new article from Sam Mamudi in the Wall Street Journal. The old adage that long-term investors should pile into equities is fading from view.

In addition, Mamudi says, many investors now want to incorporate alternative assets such as commodities into their portfolios.

"The whole 60-40 idea is almost like Betamax videotapes; it's now passe," says Andrew Silverberg, co-manager of Alger Balanced Fund, in the article. "It gained popularity while we were still in a bull market ... [Asset allocation should be] more dynamic."

Read the full article here.

Details are in the works for the launch of the first aluminum-backed exchange-traded fund, the Wall Street Journal reported Monday.

Though Glencore International, the world's biggest commodity trader, and Credit Suisse Group are still looking for both an ETF provider and regulatory approval, the new ETF is said to reflect growing interest in physically backed commodity products in the face of looming stricter U.S. regulation in the futures markets.

Abundant supplies of aluminum following a drop in demand associated with the economic downturn is also encouraging the creation of the ETF as a way to help soak up some of that supply and keep prices firm.

Recently, the price of aluminum on the London Metal Exchange has soared, trading some 50 percent higher than the seven-year lows it hit earlier this year, and though some analysts see further growth ahead, the massive inventory overhang could pose a threat to those gains. In fact, LME aluminum stocks are at record-high levels in warehouses across the globe, and that aluminum will eventually need to be absorbed by buyers.

It's not clear where the ETF will be listed, but some sources suggest it might happen on the Swiss and German exchanges.

Metals-backed ETFs have significant influence in their underlying markets, the Globe and Mail said Monday. Glencore is a large holder and trader of aluminum, and it has partnered with Credit Suisse before.

You can read the full Wall Street Journal story here.

You can read the full Globe and Mail story here.

You can read a HardAssetsInvestors.com in-depth feature on the aluminum market here.

(Editor’s Note: The following is an excerpt from an article in the Exchange-Traded Funds Report in July. Subscribers to ETFR can read the complete piece here.)

Specialty-sector ETFs—also called “thematic” ETFs—have emerged as a major force in the ETF industry.

These ETFs run the gamut of investment possibilities, but have one thing in common: They look past traditional size and sector designations to carve out new investment areas, often driven by a single investment thesis.

Clean energy, infrastructure, nuclear power—by our count, there are now more than 40 of these unique ETFs on the market, with more than $10 billion in assets under management.

Investment manager Van Eck Global has been one of the most successful companies in carving out a foothold among specialty ETFs. Its Market Vectors Gold Miners ETF (NYSE Arca: GDX) is the largest specialty ETF of all, with almost $5 billion in assets.

“We’re looking for compelling investment themes that we believe in for the long term, where the ETF basket approach can be a great tool for market participants,” said Adam Phillips, managing director of Market Vectors, “whether that be for the buy-and-hold investors or the trading community.”

Of course, some investors see things differently.

Rick Ferri, founder of the advisory firm Portfolio Solutions and author of “The ETF Book,” calls thematic ETFs “gimmicky.”

“We don’t use any thematic funds in our management here,” said Ferri. Ferri, a former broker himself, believes thematic ETFs are less popular with independent advisers than they are with brokers for a simple reason: story. He says they are an easy sale to clients who can relate to specific areas like clean water or other environmentally motivated ETFs.

“They come out when they happen to be popular in the news,” Ferri said. He believes they do well as brokers buy them up (sometimes driving the actual price of the ETF up) but that they tend to fall off six to 18 months later.

Roger Nusbaum, portfolio manager and chief investment officer for financial planner Your Source Financial, disagrees.

“In terms of long-term investing and the context of diversified portfolios, I absolutely think there’s utility [in them],” he said. Nusbaum uses them, as well as individual stocks, in his sector-based approach to portfolio construction. He has used the PowerShares Water Resources Portfolio (NYSE Arca: PHO) in client accounts since its launch, for instance, saying he tends to incorporate it as part of the allocation to industrials.

With regard to price run-ups, Nusbaum says some specialty sectors can be “faddish” in their behavior. If a fund covering solar energy jumps by 50%, and you know the industry is not going to fully develop for years to come, he suggests it might be time to reduce your exposure until the price becomes more reasonable.

Slicing & Dicing Themes

One of the most common questions asked by investors is, “Which ETF covers this?” Indeed, it’s often hard to even know what specialty-sector ETFs are available, as by definition they fall into narrow categories unlikely to be highlighted as an “asset class” in the pages of the Wall Street Journal. With so many fund launches, it can be a challenge to simply keep up with what products are on the market.

With that in mind, we have compiled an overview.

Alternative Energy

Last year’s run-up in energy prices and rising concerns about peak oil have combined to dramatically increase investor interest in energy alternatives. From relatively diversified funds to those targeting just solar or wind, investors can now use ETFs to access energy alternatives in practically any flavor they like.

Largest ETF: The PowerShares WilderHill Clean Energy Portfolio (NYSE Arca: PBW) was the first and is still the largest of these ETFs, with $743 million in assets under management. Some consider its exclusive focus on U.S.-listed names limiting, as much of the alternative energy industry is focused abroad. But the fund gains some exposure to these markets via ADRs.

Coal

Coal is the cheapest source of BTUs on the planet, easily beating oil, gas, wind, solar, hydro and nuclear. In addition, both China and the U.S. have huge domestic supplies of coal, and spiking oil prices are encouraging further development of the resource.

Largest ETF: The largest coal ETF by far is the Market Vectors Coal ETF (NYSE Arca: KOL), with $277 million in assets under management. The ETF holds a global portfolio of coal companies, primarily focused on the mid-cap miner space. It is 49% exposed to U.S. companies, with other significant positions in China (23%) and Indonesia (15%).

Nuclear

The long-term case for nuclear energy is clear and clean: The underlying fuel is so plentiful that we will never run out of it, and, when operating safely, nuclear power plants produce zero emissions. Once built, nuclear power is also the cheapest kind of energy on the planet.

Largest ETF: Three ETF companies offer nuclear energy ETFs. The largest is the Market Vectors Nuclear Energy ETF (NYSE Arca: NLR), with $166 million in assets. The fund has a large position in uranium miners (40% of the portfolio), with other concentrations in power generators and plant construction companies.

Commodities

The commodities boom raised the profile of “stuff” as an investment, and ETFs have made the area more accessible. Specialty-sector funds often focus on companies that produce commodities, like water or steel, that do not have liquid futures contracts.

Largest ETF: The largest hard assets ETF is the Market Vectors Agribusiness ETF (MOO), with nearly $1.5 billion in assets under management. Close behind is the PowerShares Water Resources ETF (NYSE Arca: PHO), with $1.2 billion in assets. Other areas of the market include steel, timber and broad-based commodity stocks.

Infrastructure

The term infrastructure is nearly as sweeping as commodities; it covers everything from companies involved in the construction and repair of roads and bridges to those that build and maintain power grids, telecommunications networks, and sewage systems. There’s no denying that infrastructure is a big deal these days: Developed countries desperately need to restore aging systems, and emerging markets need to actually build theirs. As with alternative energy, government stimulus funds can only add to the attraction of this sector.

Largest ETF: The iShares S&P Global Infrastructure Index Fund (NYSE Arca: IGF) is the largest infrastructure ETF available today, with $267 million in assets. See Murray Coleman’s feature on page 6 of this issue for a complete review of the infrastructure ETFs.

Transportation

If oil is the lifeblood of the industrialized world, transportation is the circulatory system. It’s no accident that the world’s (arguably) first stock index was the Dow Jones Transportation Average. And it’s also no surprise that there are a few ETFs focused on transportation.

Largest ETF: The Claymore/Delta Global Shipping ETF (NYSE Arca: SEA) is the largest transportation ETF, with more than $70 million in assets. SEA is sometimes seen as a leading indicator both of economic activity and commodities demand, since rising rates for ships mean incipient increases in industrial production on the receiving end of those shipments.

Green

Not only are there clean energy ETFs, but there are also ETFs that take environmentally friendly approaches in other ways. Two funds and an ETN—the only one in this survey—focus on ecological innovation, such as combating global warming.

Largest ETF: The largest ETF of the bunch is the PowerShares Cleantech Portfolio (NYSE Arca: PZD), which invests in a variety of companies whose products help improve productivity while minimizing the consumption of natural resources. PZD has $123 million in assets.

Miscellaneous

And finally, there’s the “miscellaneous” catch-all category. The funds falling into this category include the only available gaming ETF, a fund covering luxury items and another tracking the Chinese real estate market.

Largest ETF: The largest ETF of the bunch is the Market Vectors Gaming ETF (NYSE Arca: BJK), which invests in gaming (read: gambling) companies around the world. It has roughly $108 million in assets.

News Corp. is considering selling the venerable Dow Jones indexing business, including the Dow Jones Industrial Average, according to reports posted on the Wall Street Journal’s Web site on Friday afternoon.

The Journal says that Goldman Sachs is leading the sales process, which is in the early stages and is, at this point, exploratory in nature.

Many have wondered what would become of the indexing business following News Corp.’s 2007 acquisition of Dow Jones & Co. News Corp. paid more than $5 billion for Dow Jones and its crown jewel, the Wall Street Journal. The indexing piece always appeared to be an odd fit within the News Corp. structure.

According to the Journal, the indexing unit had revenues of $101 million for the nine months ending September 2007.

Dow Jones refused to comment on what it called “market rumors.”

The Wall Street Journal story is available here.

Law Firms Threatening Action Against Leveraged ETF Providers

At least two law firms say they're talking to clients who use leveraged exchange-traded funds about potential lawsuits against the funds' providers.

The list is large and includes ETFs sponsored by ProShares, PowerShares, Direxion and ETF Securities, which recently entered the U.S. (see story here.)

How do we know this? The law firms, of course, put out a press release. You can read it here.

Two Deutsche Bank Funds Hit By CTFC Ruling

A pair of PowerShares-DB commodity ETFs will be curtailed in how much they can buy in soybeans, wheat and corn due to a decision by the Commodity Futures Trading Commission.

You can read this Bloomberg News report for more details. Also, check Matt Hougan's blog here.

SSgA's Hoguet: Sovereign Wealth Funds To Buy SDRs

Special drawing rights, or SDRs, are what the International Monetary Fund uses internally as currency markers to traverse its global reach. China has nominated SDRs as a natural new world currency, replacing—or complementing—the de facto U.S. dollar.

When the suggestion was made, critics voiced their displeasure at the notion. But now, according to this interesting Reuters report, several big sovereign wealth funds are considering buying SDRs.

The report is based on information supplied by George Hoguet, a State Street Global Advisors emerging markets expert. (His work has been profiled at IndexUniverse.com several times in the past few years, including a Q&A earlier this year.)

You can read the Reuters story here.

Fidelity President Looking For Successor

Rodger Lawson, who took over as president of Fidelity Investments in 2007, tells Bloomberg News he's looking for a replacement. The position has been a bit of a revolving door at the mutual funds giant in recent years.

The story addresses that issue and also includes Lawson's rebuttal of Morningstar data showing the company is lagging its peers in performance, particularly compared with arch rival Vanguard. (For more about the battle between Vanguard and its competitors, see related story here.)

You can read the Bloomberg interview with Lawson here.

In related news, Fidelity says its assets rose to $2.8 trillion. See a Wall Street Journal story on the firm's finances here.

Hedge Fund Bets Big On Natural Gas Prices

It might be interesting to note that with all of the furor going on over UNG and commodities markets, a hedge fund has apparently made a rather large bet that natural gas prices will triple by winter.

The Financial Times story also gets into the most recent forecasts for the market from analysts and their reaction to the unusual play.

You can read the story here.

The basic power of the Fed derives from its ability to create money, which it can use to buy assets or extend loans. We can summarize the Fed's actions in terms of either the asset side of its balance sheet (the assets and loans it holds), or the liabilities side (the money or other obligations it has created). Let's start with the asset side. Up until January of 2008, by far the most important assets held by the Fed were short-term Treasury bills. As last year wore on, the Fed significantly expanded its loans in the form of currency swaps with foreign central banks, direct lending to U.S. banks through term auction credit, and the Commercial Paper Lending Facility. Altogether such measures more than doubled the various asset holdings of the Fed by the end of the year, despite the fact that the Fed sold off 40% of its original T-bills.

Figure 1. Factors supplying reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to July 15, 2009. Wednesday values, from Federal Reserve H41 release. Agency: federal agency debt securities held outright; swaps: central bank liquidity swaps; Maiden 1: net portfolio holdings of Maiden Lane LLC; MMIFL: net portfolio holdings of LLCs funded through the Money Market Investor Funding Facility; MBS: mortgage-backed securities held outright; CPLF: net portfolio holdings of LLCs funded through the Commercial Paper Funding Facility; TALF: loans extended through Term Asset-Backed Securities Loan Facility; AIG: sum of credit extended to American International Group, Inc. plus net portfolio holdings of Maiden Lane II and III; ABCP: loans extended to Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility; PDCF: loans extended to primary dealer and other broker-dealer credit; discount: sum of primary credit, secondary credit, and seasonal credit; TAC: term auction credit; RP: repurchase agreements; misc: sum of float, gold stock, special drawing rights certificate account, and Treasury currency outstanding; other FR: Other Federal Reserve assets; treasuries: U.S. Treasury securities held outright.

In 2009, the Fed has been winding down some of these programs, with significant declines in swaps, CPLF, and TAC, replaced by big increases in items such as mortgage-backed securities and agency debt. The changes over the last few months should not by any stretch be described as a return to "plain vanilla" central banking. The risk on MBS and agencies is greater than that for T-bills, and the asset level today remains 130% above its value at the start of 2007.

Where did the Fed obtain the funds with which it acquired all these new assets? To say that it did so by "printing money" would be inaccurate. The Fed doesn't lend a half trillion in term auction credit by handing out big bundles of green paper with Ben Franklin's picture on them. Instead, it creates an entry in an account that the recipient bank has with the Fed known as the bank's Federal Reserve deposits. The bank could, if it wanted, use those credits to ask the Fed for those Ben Franklin souvenirs. Instead the bank presumably used the new deposits to pay for some obligations or make some loans, either of which it would instruct the Fed to implement by transferring those reserves to some other bank. That bank in turn could use the reserves to ask for C-notes, or pass them on to somebody else through its own loans or any other expenditures.

And the buck stops-- where? In normal times, the process of banks putting any excess reserves to use would continue until there's enough expansion of banking and economic activity that ultimate recipients did want to turn those reserves into green currency. And once that happens, it would not be a misleading summary of the bottom line to say that the Fed eventually paid for its original asset purchase by "printing money".

But in the fall of 2008, the Fed did not want that to happen. It wanted to extend a trillion in new loans, but it did not want to see currency held by the public go up by a trillion dollars, out of fear the latter would be very inflationary. The Fed's thinking was that we didn't need a traditional inflationary expansion of credit, but instead needed to allocate credit to particular functions without having conventional measures of the money supply swell.

The graph below describes how the Fed did that, looking now at the liabilities side of the Fed's balance sheet. The height of Figure 2 at any date is identical, by definition, to the height of Figure 1, but whereas Figure 1 was looking at what the Fed did with its funds, Figure 2 summarizes how the Fed obtained those funds. In other words, Figure 2 looks at where the reserve deposits the Fed created ended up, and explains why the dramatic actions of Figure 1 haven't yet shown up as currency held by the public.

Figure 2. Factors absorbing reserve funds, in billions of dollars, seasonally unadjusted, from Jan 1, 2007 to July 15, 2009. Wednesday values, from Federal Reserve H41 release. Treasury: sum of U.S. Treasury general and supplementary funding accounts; reserves: reserve balances with Federal Reserve Banks; misc: sum of Treasury cash holdings, foreign official accounts, and other deposits; other: other liabilities and capital; service: sum of required clearing balance and adjustments to compensate for float; reverse RP: reverse repurchase agreements; Currency: currency in circulation.

One big factor has been the accounts that the U.S. Treasury holds with the Fed. Essentially, the Fed asked the Treasury to borrow some money through public auctions, which it did. Banks paid for these new T-bills by instructing the Fed to transfer to the Treasury the Federal Reserve deposits that they'd received from the Fed as a result of the programs in Figure 1. The Treasury then just left the funds sitting there in its accounts with the Fed. In effect, the Fed obtained the funds for some of its actions on the asset side not by "printing money" but instead by having the Treasury borrow funds on its behalf on the liabilities side.

However, an even bigger volume of the deposits that the Fed created are still just sitting on the banks' books. The way the fed funds market functioned in 2007, that would never have happened. Why close your bank's books for the day with funds just sitting there in an account with the Fed, earning no interest, when you could loan them out overnight instead? A big bank would never do such a thing in 2007. But they're happy to do so in 2009, in part because the overnight lending opportunities are not particularly attractive at the moment, and in part because the Fed now pays interest on those reserves. From the bank's point of view, funds left on deposit with the Fed at the end of the day aren't idle at all, under the new system adopted in the fall of 2008.

One of the points that Bernanke makes in his op-ed is that the Fed could continue to use this device, if need be, to prevent essentially any volume of its asset side activity from showing up as an increase in currency held by the public, simply by raising the interest rate the Fed offers to pay on reserves to whatever level is necessary to persuade banks to continue to hold these funds idle overnight. In effect, the Fed is through this device borrowing directly from the public to fund its asset-side activities rather than by "printing money".

Should that allay any inflationary concerns people may have about the doubling in the size of the Fed's balance sheet? In a narrow mechanical sense, perhaps. It is true that the new assets have not yet shown up as an increase in the money supply, and it is true that the Fed has the power to prevent them from doing so in the future. But my concerns about inflation are not that the Fed would lose the ability to target a particular level for the money supply, and certainly are not concerns about the next six months, where I still see deflation as a bigger worry than inflation. Instead, my concern is that the current fiscal trajectory is fundamentally inconsistent with the Federal Reserve choosing to keep inflation under control. Both devices, ballooning of the Treasury's account with the Fed and enabling the Fed in effect to borrow directly on its own, are indeed as much fiscal measures as they are monetary. But to someone worried about the increasing co-mingling of monetary and fiscal policy, that blurring of the lines is not a reassuring development.

My specific worry is that we will eventually face a crisis of confidence in the Treasury and the dollar itself. It is true, as Bernanke suggests, that raising the interest rate paid on reserves in such a setting would be a policy tool that could be used in response. But it would be an unattractive measure to the point of perhaps being impossible to use in practice, for the same reason other countries have dreaded raising interest rates in the face of collapsing real economic activity and a flight from their currency.

I fear that the United States government is mistakenly assuming that it can borrow essentially unlimited sums without undermining confidence in the dollar itself. The real question of a successful exit strategy, in my opinion, is how do we extricate ourselves from the joint fiscal commitments currently assumed by the Treasury, the Fed, the FDIC, the Medicare and Social Security trust funds, and various and sundry implicit and explicit federal guarantees?

The answer, in my opinion, is not to be found in the Treasury doing even more borrowing on behalf of the Fed or the Fed doing even more borrowing on behalf of itself.