In the battle over interest rates, it’d be unwise to bet against the RBA

After years of repeatedly missing its inflation target through too timid monetary policy, in the past week the Reserve Bank has decided to get tough.

Not only did it hold its closely watched cash rate target steady at 0.10% at Tuesday’s board meeting, it ramped up its efforts to defend its separate 0.10% target for the three-year government bond rate in the face of a mini-revolt by bond traders.

A few weeks back, some of the traders in Australia and elsewhere got it into their heads that big borrowing by governments would force up bond rates – a relationship that was once thought to be clear cut but hasn’t held for some time.

The traders sold government bonds issued by Australia and other nations, which in the case of the bond market, forces up the bond interest rate.

Then other traders piled on, partly because economic outlooks are improving and they thought governments might soon be issuing fewer bonds, and partly because they thought other traders might agree with the traders.

That’s right: “thought other traders might agree with the traders”.

Beauty contests can make markets mad

In financial markets you don’t make money by correctly guessing what will happen, you make it by correctly guessing what other traders think will happen.

One of the founders of modern economics, John Maynard Keynes, described it as a beauty contest in which judges are rewarded not for picking the most beautiful face, but for picking the face other judges will think is the most beautiful.

It’s like the rules in Family Feud.

The yield on Australian Commonwealth 10-year bonds climbed from 0.98% at the start of the year to 1.11% a month later, to an extraordinary 1.87% a month after that – a near-doubling in a matter of weeks.

Even the yield on three-year bonds, which the Reserve Bank has pledged to keep at 0.10% crept up to 0.13%.

Last Friday, the Reserve Bank fought back.

It bought extra bonds a day after completing its usual purchases on Thursday.

This Tuesday, in its statement after its monthly board meeting, it added nine words to its usual acknowledgement that “wage and price pressures remain subdued”.

Those words were: “and are expected to remain so for some years”.