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CNBC explains: The Bank of Japan's 'yield curve control'

The Bank of Japan has taken the era of financial engineering into an entirely new dimension.

As investors still struggle to grasp concepts such as quantitative easing and negative interest rates, the BOJ now has introduced "yield curve control" in an effort to boost its moribund economy.

Essentially, the policy will entail keeping its 10-year government bond yield at zero. Generally, it's thought that central banks can control only short-term interest rates, but the BOJ believes that its own form of quantitative easing will help control the 10-year and steepen the yield curve — that is, increase the difference between the yields of short-term bonds — which are negative in Japan — and long-term bonds.

One likely side effect of "yield curve control" is that it will increase profitability for banks, which depend on a wider spread in rates in order to arbitrage profits.

Generally speaking, greater banking activity leads to greater economic activity and higher inflation. Regardless, however, most analysts figure the gains in Japan will be incremental.

Central banks around the world have been engaged in an energetic but mostly futile battle to generate inflation. The BOJ's efforts have been on some levels even more aggressive than the Federal Reserve, which has expanded its balance sheet to $4.5 trillion but has been unsuccessful in generating much inflation.

A man rides a bicycle past the Bank of Japan building in Tokyo.
Yuriko Nakao | Reuters
A man rides a bicycle past the Bank of Japan building in Tokyo.

The key, though, will be the quantity of bonds the BOJ will have to buy. Its announcement provided little in the way of details.

"The language on 'yield curve control' was very vague," Peter Boockvar, chief market analyst at The Lindsey Group, said in a note. "They want to steepen the yield curve but barely. With the short end at -.10 percent and their desire for a zero yield out 10 years, that is not very steep!"

The move is evidence of "policy exhaustion," Tomoya Masanao, head of portfolio management for Japan at bond giant Pimco, said in a note. The move "is a clear regime shift from base-money targeting to yield-curve targeting against the 'new neutral' yield curve."

The "neutral" rate is that which strikes the proper balance of economic growth. Monetary policy experts in recent days have surmised that the rate probably is considerably lower than most central bankers had been estimating.

For Japan, yield curve control is yet another step in a lengthy battle to gin up an economy that, like many others across the globe, appears to be sinking further down a deflationary hole.

"The BOJ will stay in the game for many years but will no longer take the lead," Masanao said. "The BOJ alone cannot win the deflation war, unless economic growth expectations increase."