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Alan Greenspan spoke in front of a Senate hearing committee Wednesday morning. That probably doesn’t mean much to most people, but for us industry folk it’s quite significant. Although retired, Greenspan’s remarks still attract attention from Wall Street and have a definite impact on public opinion.

His recent successor, Ben Bernanke, hasn’t yet mastered the graceful approach used by Greenspan to disseminate information to the public. The result has been a highly volatile stock market trying to digest news about the economy.

The Federal Reserve Bank’s primary goal at this point is to contain inflation while simultaneously sustaining economic growth. Economics 101 teaches us that the Fed uses its most valuable tool, Monetary Policy, to achieve these goals.

The most popularly discussed policy action is to raise and lower interest rates. Interest rates reached historically low levels after the technology bubble of 2000 and 9/11. Banks tried to encourage both business and personal spending by offering money at rates in the 3-6% range.

From a historical perspective, the ability to lock into a 30-year, fixed-rate mortgage for an interest rate under 6% was an excellent opportunity- one which contributed to the booming housing market which followed. Five years later, interest rates are creeping back up at a steady pace- as is inflation. As we combat inflation, we are really battling one thing- Oil.

What’s going on with Oil?

We’ve all seen the prices at the pumps, but what exactly is causing the price of oil to go up? Keep in mind that no single factor is causing the rise in oil prices. It’s a combination of factors coming together at the same time.

The first explanation is a decline in spare global oil production capacity. We have less spare oil, because demand for oil continues to rise. Naturally, heavy demand stems from the United States. However, as we evolve into a global community, we’re seeing the demand for oil from the Far East and Europe increase at rates that dwarf those of the past. Remember, besides water, oil is the world's most demanded commodity. Because of its limited supply, the price continues to climb.

What further contributes to expensive oil is the cost of refining. When oil is discovered, it’s a rough, crude oil which needs to be refined prior to use. The refining industry is huge, but not particularly feasible here in the United States. Areas of the world including the Middle East and Canada have the infrastructure in place to refine quickly and efficiently. Our main hub for oil production in the US is the Gulf, which has taken a beating with the hurricanes and made refining even less likely to occur here at home.

A final cause for increases in oil price is market speculation. The futures industry allows speculators to lock into a future price for oil today. Because of turmoil in the Middle East and the supply and demand issues mentioned above, some firms have been locking in future oil prices per barrel in the $70 range, hedging against the possibility of $80+ oil. This speculation has sent jitters to markets in both the US and abroad.

Alan Greenspan in his testimony to Congress said one thing which I found to be particularly interesting: he commented on risks associated with “Protectionism” as practiced here in the US. What Greenspan is referring to is the free market system. The US has a very global attitude towards competition. Our encouragement of free markets has dramatically improved trade relationships and both prices and availability of consumer goods recently. The concern is if we push too hard to protect domestic producers of oil (those who may be negatively affected by globalization), it will dramatically increase our costs at home. This could translate into high oil prices becoming a longer term problem along with increased volatility in the stock market.

So how should we react to the oil and interest rate concerns?

Well, I wouldn’t lose sleep over it. I’ve watched the markets take a step backwards more than once in my life. This past month pales in comparison to what we’ve seen in the past. What I recommend doing is focusing on where the economy is headed and prepare for it going forward.

I would speculate that market gains will moderate for the next year or two as political instability continues in the Middle East. Allocate your portfolio more towards bonds and other fixed-rate investments if you are adamant about watching your portfolio gain in value. Markets don’t like instability and it seems like we’ve had too much of it for comfort.

In terms of oil prices, prepare for oil to become a personal “tax” and budget for it. If you are really feeling the oil squeeze, try to evaluate your spending patterns and see if perhaps further budgeting could help.

As for interest rates, we’re nearing a neutral level in which inflation will contain itself and economic growth will moderate. The Fed will probably raise rates one more quarter point at the end of June- and I believe that raise is already factored into the stock market. If you’re considering a home purchase, don’t jump into a variable-rate product. You might profit briefly with a variable interest rate, but long-term planning requires locking in a figure which you can plan for.

Crude price chart:

Crude prices

Source: The Economic Forecast: Rising Oil Prices with a Chance of Scattered Inflation