their economic decisions to a larger extent than any single buyer. this strengthens the incentive for suppliers to hedge against adverse fluctuations in spot prices. traditionally, the market for oil futures has been a “ sellers ’ market. ” and sellers have been on average happy to pay a premium to market traders willing to buy a futures contract and take upon themselves the risk of future spot price declines. “ backwardation ” means that buyers as a whole normally agree to provide this insurance if they can expect to earn a positive premium on top of the expected change in the future price of oil. 16 assuming that the best predictor of the spot price in the future is the current spot price, the spread between the current spot price and the futures price reflects the remuneration for the risk that buyers as a whole accept to bear. 17 over the last two decades when backwardation has been the norm, the risk premium paid by hedgers to financial investors has been relatively stable, moving predictably with the spot see, for example, domanski and heath ( 2007 ). although physical delivery of oil may occur, this in reality occurs rather rarely. contracts are instead liquidated before expiration usually leading to exchange of cash among market participants. so, for example, while an airline normally buys jet fuel through its usual physical supplier, it can purchase a futures contract to hedge possible price increase over the subsequent months. if the price actually rises, the gain from liquidating the futures contract towards expiration will offset the loss from the greater cost of fuel. the opposite situation in which the term structure of futures prices is upward sloping is known in traders ’ jargon as “ contango ”, and has traditionally occurred less frequently than “ backwardation ”. some financial participants may be enticed to buy or sell futures contracts by different views on the future oil price than the market. but on average financial participants are net buyers and assuming that they are on average no better than sellers in predicting the future spot price, they will need a discount over the price expected at the expiration of the futures contract to be motivated to purchase it. this risk premium is the mirror image of what sellers as a group are willing to give up for the benefits of holding physical inventories of oil, which have the important role of ensuring the continuation of production and sale in the face of potential disruption in the oil supply chain. in jargon inventories provide a “ convenience yield ”, which in the oil market can be quite sizeable. the

and ourselves foresee that the official cash rate will not need to rise as far in this cycle as it did in the last one. there are a number of reasons for this, none of them individually definitive, but all pointing in the same direction : in brief the financial markets have already effectively tightened conditions as a result of more costly funding ; the new zealand private sector is reducing debt and cautious about new borrowing ; most borrowers are on shorter duration mortgages and the steeper yield curve does not much encourage lengthening this ; increasing policy rates in the shadow of australia should be easier than being a world leader ; and, finally, we believe there may be alternative ways of influencing over - exuberant bank lending through macrofinancial policies. our economic recovery is out of its first stage of intense fragility, and into a new phase of rebalancing growth. but a final caution : recovery so far has been full of surprises. there will be more to come!