Many people are saying that the rise in oil prices is the result of loose monetary policy. They say that there is an easy solution to the problem. Raise interest rates substantially, and the problem will be solved. Since the rise in oil is also the primary cause of rising inflation, the inflation problem will be resolved as well.

There are several problems with this line of reasoning. Oil continued to rise as the Fed began to increase interest rates in 2004. Prices doubled as the Fed substantially tightened monetary policy. Europe also has the some of the same inflation issues that we face despite the refusal of the European Central Bank (ECB) to lower rates.

Then, there are the big questions. Why are oil prices rising? What is the short-term solution?

I believe that the main reason for the rise in oil prices is the rise of the developing world. The two nine hundred pound gorillas in this equation are India and China. Automobile demand is increasing in these countries and is likely to continue in the near future.

This is similar to the rise in oil prices in the late 1960's and early 1970's. After World War II, the United States was the primary industrial power. As the world industrialized, demand for oil increased. The United States was not the only nation driving cars extensively. Supply constraints were also introduced in the mid to late 1970's with the Arab oil embargo and the Iranian revolution.

Is there a short-term solution for the problem? Eventually, the situation reaches a "tipping point." Demand decreases because of substitution for other forms of energy, and alternative supplies are developed. When will this occur? No one is really certain.

During the time period prior to this tipping point, inflation from rising oil occurs. The Fed could conceivably raise interest rates substantially enough to cause a severe global recession. The decrease in demand could temporarily lower oil prices. However, the cure may actually be worse than the disease. In addition, as the world economy recovered, oil prices would begin to rise again.

Therefore, the Fed is forced to tolerate inflation until this tipping point is reached. It hopes to be able to prevent these inflationary expectations from becoming embedded in the system.

This is further complicated by current housing decline and the credit crisis. If the Fed adopts a monetary policy that is too tight, it could cause a severe recession.

Thus, the current environment of real interest rates (interest rates adjusted for inflation) being negative may continue for some time. This favors small-cap stocks. An extended negative real interest rate environment indicates some type of a small-cap rally. As we saw at the beginning of this decade, small caps' performance advantage over large-cap stocks as represented by the S&P 500 can be quite substantial.