Are we in bubble territory? Divining the mind-set of the Philippine central bank

From the conclusions of a paper written by Bangko Sentral staff in 2004:

It is even more difficult to determine the right magnitude of interest rate to burst the bubble. For this reason, monetary policy need not be preemptive during the boom period. Raising interest rates too soon could precipitate an asset price collapse with its adverse effects on financial markets, the financial system and eventually a protracted fall in output below its potential and inflation below its target.

The paper continues:

Whatever monetary approach that may be adopted, the best safeguard against asset price fluctuations is for monetary authorities to work for an environment conducive to sustainable economic growth which includes price stability and financial system stability.

What do these pronouncements mean?

Staff papers written within central banks are typically highly scrutinized by higher-ups before publication.  This means that the conclusion hints at how the Philippine monetary authorities are likely to react in the face of asset bubbles, such as in the stock market.  The first part of the conclusion suggests a “hands off” approach to bubbles, and the second part justifies this by saying that such an approach is all right if the environment is one of sustainable growth with price stability and financial system stability.

It is of course correct to say that it is difficult to see a bubble while it is “early” but easy when it has already burst.  Humans tend to rationalize that uptrends in asset prices are “fundamental” and not driven by speculative greed or “irrational exuberance.”  And fear that sets in after a bubble has burst causes the correction to be more severe than otherwise.

The Philippine central bank accordingly believes in a more or less “hands off” approach to bubbles, so long as it stays “on course” on its primary goal of maintaining price stability, where “price” here refers to consumer prices or GDP deflators, and not to asset prices.  And so long as “fundamentals” of economic growth are evident.

But it is a given in monetary history that bubbles emerge, although typically they do so with the aid of monetary expansion by central banks.  This means there is a significant chance that bubbles will continue longer than they would normally.

I believe that the Philippine stock and real estate markets have already begun, as of mid-2010, to exhibit “bubbly” characteristics.  Whether we will have “true” bubbles remains to be seen, but if bubbles were to emerge, it seems that the authorities will “tie their hands,” because, as stated in the staff paper, “monetary policy need not be preemptive during the boom period.”

Conclusion: There will be good times ahead in the stock and real estate markets in the Philippines.  If these “good times” get to be too good, it will be risky for investors who decide “to play the bubble,” because a bubble inevitably brings on a crash, and there are no easy ways of forecasting when a bubble will burst.


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