When Will China's Inflation Subside?

China's central bank raised rates for the third time since mid-October—and its fight against inflation isn't over yet.

The People's Bank of China raised the one-year lending rate by a quarter-point on Feb. 8, to 6.06 percent. The one-year deposit rate went up an equivalent amount, to 3 percent. The PBOC moved before a report in mid-February that may show consumer prices rose 5.3 percent in January, according to the median estimate in a Bloomberg News survey of economists. "There is still a substantial amount of heavy lifting to do in terms of rates—at this stage of the cycle, the fact that we still have negative real rates is quite alarming," says Glenn Maguire, chief Asia economist at Société Générale in Hong Kong.

Premier Wen Jiabao's government has yet to return rates to their higher pre-crisis levels. Now, with overheating a danger in the first half of the year, policy makers are likely to raise their benchmark interest rates further, order banks to set aside more cash as reserves, and let the yuan appreciate to stem price pressures, Wang Qing, a Morgan Stanley (MS) economist in Hong Kong, wrote in a note on Feb. 7. Wen's government is selling state food reserves to lower food prices, providing more low-income housing, and cracking down on speculation and hoarding.

A drought that's threatening grain output and a New Year surge in lending are adding to inflation risks. Economic growth accelerated in the fourth quarter, to a 9.8 percent annual pace.

In the Feb. 8 move, the People's Bank raised long-term rates for deposits more than it did for loans. For savers, the increase was as much as 45 basis points for five-year deposits. "The goal is to encourage savers to keep their money in bank deposits rather than shifting to equities or property," says Mark Williams, a London-based economist at Capital Economics.

Companies from Baoshan Iron & Steel to Starbucks have raised prices. While wages are also climbing, Chinese consumers are more concerned about inflation than at any time in the past decade, according to a central bank survey released in December.

The government knows January's inflation number will "look ugly" and wants to be seen as acting in the lead-up to the annual meeting of the National People's Congress in early March, says Ma Jun, Deutsche Bank's (DB) chief China economist. China aims to hold inflation at 4 percent this year, state broadcaster CCTV reported in December. To get there, Isaac Meng, a Beijing-based economist for BNP Paribas, says he expects "accelerated tightening," with rates rising by as much as an additional 1.5 percentage points.

The bottom line: China is still fighting inflation after three interest rate hikes. Economists expect further rate hikes before inflation is subdued.

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