The People's Bank of China (PBOC) announced on Feb 8 that it would raise the benchmark lending and deposit rates effective from Feb 9. The rate hike appears to be symmetric as both the benchmark 1-year lending rate and the 1-year deposit rate have been raised by 25 basic points. The PBOC also raised the demand deposit rate by 4 basic points, and aggressively raised the deposit rates of longer maturities. We think this is a de facto asymmetric rate hike, with average deposit rates rising more aggressively than market expectations.

The government and the PBOC are clearly concerned about the fact that negative real interest rates would exacerbate inflation, and the January CPI to be released around Feb 20 may look high.

It seems the PBOC has refrained from raising lending rates more aggressively partly because actual lending rates have gone up quite substantially in recent months, and the smaller move on benchmark lending rates can be seen as an effort to avoid over tightening. The other likely reason is that with the recently announced "third round" property cooling measures by the State Council, a sharp increase in long-term lending rates would be too harsh on the property market.

However, the rate action won't significantly affect overall market performance, as it had been expected. But the government does need to slow China's economic growth to combat inflation. This year China's GDP will grow at 9 percent or above. Such robust GDP growth will boost the country's employment, and might even exacerbate the labor shortage problem when the country's labor force supply is already on the decrease. But the big threat is inflation. The annual CPI inflation for 2011 will rise by 4.5 percent and close to 5-6 percent in the late second quarter, indicating the challenge of controlling price inflation to below 4 percent.

Moreover, China is facing more inflation pressures than the CPI indicates. According to a recent depositor survey by the PBOC, respondents' satisfaction with prices has dropped to a record low over the past 11 years, thanks to the leapfrogging commodity prices and the soaring house prices.

Taking commodity and house prices into account, China is probably under greater pressure.

To make things worse, unmanageable factors, such as inflation expectations and the international oil price, aggravate inflation.

For instance, inflation expectations can expedite capital flow by sparking inflation fears and thus cause greater inflation pressure.

Obviously, prevention of inflation and the pursuit of high economic growth are incompatible for the present.

China should worry about higher inflation rather than lower economic growth. The emphasis should be on anti-inflation with other goals, including economic growth, giving way. Otherwise, inflation will get worse in the following ways and ruin the country's economic and social prospects.

First of all, inflation per se spurs expectations of further inflation, which in turn aggravates inflation. For instance, despite the second round of real estate regulations to curb mortgage loans and adjust mortgage rates, house sales settled in full continue to surge, because taking inflation expectations into account, many residents are rushing to buy houses in case prices go even higher. What's more, inflation has already raised the cost of living.

With no immediate measures taken to address inflation, the increasingly high inflation will drive macro policies into a tight corner and trigger an economic slump. Even worse, inflation will further widen the wealth disparity and thus affect social stability.

To address the inflation problem, China has to locate the root cause. The current inflation problem results from the excessively loose monetary policy. Anti-inflation requires a tighter monetary policy and a slow down in economic growth.

Nevertheless, according to media reports, the growth target for China's broad money supply (M2) in 2011 is around 16 percent, and uncertainty still remains over loan growth, which is probably set around 16 percent and will finally turn out to be 17 percent or above. Such a monetary policy is still loose.

If China kept M2 growth below 15 percent and capped new local-currency loans at about 6.5 trillion yuan ($986 billion), then the country's GDP growth this year would be 8.5 percent. Given the current situation, this is an ideal policy combination, conducive to sustainable economic development and economic restructuring.

In a bid to tighten monetary policies, China will have to raise interest rates on a comparatively frequent basis.

This is because negative interest rates have already fueled high inflation expectations and thus stirred up hoarding, profiteering and real estate bubbles.

The low interest rates combined with the loose monetary policies in recent years also account for the real estate bubble in some major cities. If China clings to a loose monetary policy to boost economic growth, negative interest rates will continue to plague the country's economy and while the soaring house price, thanks to the third or even fourth round of real estate regulations, will hopefully be depressed, it will simply be on a temporary basis.

In fact, with the current macro control and policies, house prices can hardly decline. Administrative measures will help restrain speculation, but real demand will grow because of high inflation expectations and negative interest rates.

This is because, as was mentioned above, residents assume that house prices will rise.

Due to the negative actual interest rate, many of those who were planning to buy a house in the next few years have decided to bring their schedule forward. For these homebuyers, it is a case of buy now or buy later at a higher price. No wonder demand is on the rise and beyond administrative control.

The author is chief economist of Greater China, Deutsche Bank.

(China Daily 02/10/2011 page9)