"Monetary policy can cause bad things to happen in financial markets, which can cause bad things to happen in the rest of the economy. Therefore NGDP targeting is wrong."
I made up that quote. But if I had to summarise M.C.K.'s long article in two short sentences, that is how I would do it.
Here's a longer passage from M.C.K.:
"Banks and other financial intermediaries usually create credit whenever they can earn what they believe is a risk-adjusted spread between their funding costs and the rates they charge their borrowers, both of which are affected, if not determined, directly by the monetary authority. Tobias Adrian and Hyun Song Shin have shown that the balance sheets of financial firms that mark their assets to market grow and shrink based on changes to the level of short-term interest rates. Meanwhile, Markus Brunnermeier and Yuliy Sannikov have shown that monetary policymakers can alter the willingness of banks to create credit by adjusting the shape of the yield curve."
Yes, if the central bank raises or lowers interest rates, this will affect financial markets. But I thought we had gone beyond thinking of monetary policy in terms of raising or lowering interest rates. Or buying or selling bonds in an open market operation. Or raising or lowering the money supply. Or raising or lowering the exchange rate. Those aren't monetary policies.
Targeting 2% inflation is a monetary policy. Keeping the money supply growing at 4% per year is a monetary policy. Keeping the exchange rate fixed at $0.95US is a monetary policy. Targeting "full employment" (at least, trying and failing) is a monetary policy. Following the Taylor Rule is a monetary policy. Targeting a 5% level-path for NGDP is a monetary policy.
We can debate the merits of those different monetary policies. Which one is best?
A monetary policy is not just the central bank doing something right now. A monetary policy is some sort of rule that tells the central bank the different things it should be doing under all sorts of different circumstances in the past, present, and future.
We have to think of monetary policy that way. First, because the effects of the central bank doing something right now, and whether those effects are good or bad, will depend on the circumstances. Second, and more importantly, what the central bank does right now isn't the only thing that matters. What it did in the past matters too. And what it is expected to do in the future matters even more.
Suppose I argued that inflation targeting was a bad policy, because targeting inflation might require the Bank of Canada to raise interest rates, which would cause the exchange rate to appreciate, which would cause Aggregate Demand to fall, which would cause a recession. A defender of inflation targeting would say "Hang on; wouldn't the Bank of canada only raise interest rates when AD was growing too strongly anyway? And if rasing interest rates would cause an exchange rate appreciation which would cause a fall in AD which would cause a recession, wouldn't it also cause inflation to fall below target? So why would the Bank of Canada do it, if it were targeting inflation?"
Inflation targeting doesn't mean ignoring the exchange rate. Of course the Bank of Canada will look at what is happening to the exchange rate when it chooses the overnight rate to keep inflation on target. The exchange rate is one of many indicators that give the Bank of Canada the information it needs to keep inflation on target.
If I were seriously worried about the possible bad consequences of exchange rate fluctuations, and if I thought there were a genuine conflict between keeping inflation on target and avoiding those bad consequences, I ought to propose a monetary policy like fixing the exchange rate. Fixed exchange rate vs inflation targeting; which one is best? That's a proper debate between two proper monetary policies.
Or maybe a hybrid policy would be better than both. Perhaps the central bank should target the sum of CPI inflation plus exchange rate depreciation?
It would be the same if I argued that targeting NGDP was a bad policy, because targeting NGDP might require the central bank to lower interest rates, which might cause asset prices to rise, which might have bad consequences.
If I were seriously worried about the possible bad consequences of financial market fluctuations, and if I thought there were a genuine conflict between keeping NGDP on target and avoiding those bad consequences, I ought to propose a monetary policy like (say) targeting asset prices. Targeting asset prices vs targeting NGDP; which one is best? That's a proper debate between two proper monetary policies.
What would happen to the real economy if the central bank did whatever it takes to keep asset prices, or total credit, or whatever, growing at a steady (say) 5%? Can you think of any circumstances under which keeping financial markets stable might destabilise the rest of the economy? Which one matters most?
Unless you propose an alternative monetary policy target, we can't even begin the debate.