One of my key recommendations to central banks to reduce the political costs of a vigorous negative rate policy is to use the interest on reserves formula to subsidize the provision of zero interest rates to small household checking and savings accounts, as you can see in my posts “How to Handle Worries about the Effect of Negative Interest Rates on Bank Profits with Two-Tiered Interest-on-Reserves Policies” and “Ben Bernanke: Negative Interest Rates are Better than a Higher Inflation Target” and “The Bank of Japan Renews Its Commitment to Do Whatever it Takes.” (Also see “How Negative Interest Rates Prevail in Market Equilibrium” for a discussion of how the marginal rates that matter most for market equilibrium can be negative even if many inframarginal rates are zero.) 

If rates become quite negative, this subsidy could become a significant cost to the central bank, since funds from private banks put into one tier of reserves would be getting a zero rate from the central bank, but after putting those funds into T-bills, the central bank could be earning a deep negative rate on those funds, say -4%. Nevertheless, I think central banks can handle the expense. This post explains why. (Talking to other economists at the Minneapolis Fed’s Monetary Policy Implementation in the Long Run Conference yesterday helped a lot in figuring this out.)

First, the transition to negative rates will create a large capital gain for the assets on the central bank’s balance sheet, while most of the central bank’s liabilities are shorter term or floating-rate liabilities and so do not go up as much in price. This includes paper currency as a liability, since in an electronic money policy that allows deep negative rates, the paper currency interest rate is a policy variable set equal to a rate close to the target rate. (See “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”)

Second, the fact that the central bank can create money means that it cannot face a liquidity constraint as long as it is ultimately solvent. And the ultimate solvency of a central bank must be judged in the light of all future seignorage the central bank is likely to earn, ever, even if that ability to earn future seignorage is not represented by any asset that can be immediately sold.

As long as the central bank is trying to stimulate the economy, there is no problem with it creating additional money to pay all of its bills, including to pay its losses on its holdings of negative-rate Treasury bills. When it is time to tighten, any central bank that can pay interest on reserves doesn’t have to have an asset to sell in order to tighten monetary policy. Interest on reserves can be paid by newly created reserves using a central bank’s fundamental authority to create money. As long as there will be seignorage someday sufficient to mop up those extra reserves, this is a perfectly good way to tighten monetary policy.

Third, what matters for the sustainability of paying positive interest on reserves once it is time to tighten is the amount of seignorage the central bank could earn if it needed to. In an emergency, an electronic money policy allows for the possibility of seignorage from paper currency interest rates below the target rate, say by as much as 5% below.

Fourth, the markets will expect that the central bank is ultimately backed by the fiscal authority. Note that because it faces no liquidity constraints, the central bank can always wait and wait and wait for a very propitious time to beg the fiscal authority for an infusion of funds. And the markets know this. So the solvency of the central bank depends on the willingness of an exceptionally favorable fiscal authority at some future date to give it an infusion of funds. (To that exceptionally favorable fiscal authority, the central bank can argue that the deep negative rates that cost it a lot in subsidies saved the fiscal authority a lot of interest expense.)

Fifth, given whatever large present value of subsidies to support zero rates to small household borrowers a central bank has the resources for, the central bank can afford to front-load the subsidies. Deep negative rates will probably be needed only for a short time, and if necessary, an announcement that without help from the fiscal authority the cap on the amount subsidized for a zero rate in checking and savings accounts will have to be gradually reduced will probably get some help from the fiscal authority, and if not can actually be carried out.

The bottom line is that a central bank is unlikely to get into serious budget trouble from subsidizing zero rates for small household accounts even if it takes rates to a quite deep negative level.