Interest Rates and Oil Prices

In June of 2003 a barrel of oil was around $30. In June of 2006 a barrel of oil was roughly $70. So over the 3 year period from June of 2003 to June of 2006 a barrel of oil increased in price from $30 to $70. The price of a barrel of oil increased 2.33 times over the 3 year period.

The 2.33 times increase in the price of oil has caused a great deal of commotion in the United States. Consumers are angry about the rise in the price of oil which translates into a rise in gasoline prices. Some people have taken to protesting the gas price increases in front of gas stations with signs and slogans. The media has made a big deal about the sharp rise in oil prices. And even Congress has made a lot of noise about doing something about the rise in oil prices. Even threatening OPEC with anti-trust legislation and lashing out at oil executives.

All of which is somewhat justified. Crude oil has risen very sharply in price over a very short period of time. As someone who used to drive for a living and still loves to drive the rise in gas prices has been very frustrating to me. Has demand for oil really risen 2.33 times over the last 4 years? Yes, China is using more and more oil everyday and the World economy has done well over the time frame so some of the increase is justified but all of it? Since I own stock in a company which owned oil refineries I understand some of the increase is from lack of new refining capacity. Still the increase in price is hard to take and a real pain.

In June of 2003 the Federal Reserve started raising interest rates. At that time the Fed Funds Rate was 1.00%. In June of 2006 the Federal Reserve stopped raising interest rates and the Fed Funds Rate was 5.25%. So the Federal Reserve raised the Fed Funds Rate from 1.00% to 5.25% in 3 years. The Federal Reserve increased the Fed Funds Rate 5.25 times from what it was over the 3 year period.

As bad as the rise in oil prices has been it pales in comparison to the rise in interest rates, especially short term rates. Short term interest rates have risen by 5.25 times from what they were just 4 years ago. That is a massive increase. If oil had risen by the same percent a barrel of oil would be $158.00 dollars today. How would you feel about that type of increase? At that price for oil, gasoline would probably be close to $8.00 per gallon.

Yet as short term interest rates have risen so massively in such a short period of time you barely hear boo about the increase from consumers or the media. Nobody is standing in front of the Federal Reserve with signs and chanting protests like they have at gas stations. And Congress, which overseas the Federal Reserve and regularly has the Chairman of the Federal Reserve testify before appropriate Congressional Committees, has been even quieter. Barely a peep about the massive increase in short term rates even though the massive increase has had a far more damaging impact upon their constituents. How would Congress treat the head of OPEC or leading oil executives if they testified? Especially if oil had risen by 5.25 times from what it was in June of 2003?

While we all use oil in the form of gasoline or in other ways, nearly every business and consumer in the country has debt of some type. The rise in interest rates has been far more damaging to the economy than the rise in oil prices. The problems in the sub-prime lending arena can be attributed in great part to the massive increase in short term interest rates orchestrated by the Federal Reserve. Banks and other lending institutions are now putting ever larger reserves away for what they feel will be a period of increasing loan defaults.

The Federal Reserve claimed it needed to increase the interest rates to keep inflation under control but raising interest rates to deal with inflation is about as effective as putting a screen door in a submarine. If raising or lowering interest rates could control inflation than economies with high interest rates would have little or no inflation and economies with low interest rates would have high inflation rates. In the real world economies with the lowest interest rates over the last 20 years, like Japan, have had the lowest inflation rates while economies like Mexico and Brazil with the highest interest rates have also had the highest inflation rates.

So scream, holler and protest all you want about the rise in oil and gas prices but keep in mind that you should be at least as angry, actually 2.25 times as angry (5.25 divided by 2.33), at the Federal Reserve for massively increasing short term interest rates over a very short time frame.