This increase in the inflation rate is more alarming if looked at from the perspective of a month-on-month reading, which accelerated to 0.7 per cent in October from 0.6 per cent in August and September. This implies that the annual inflation rate is already running at above 8 per cent, and is perhaps why a senior policymaker admitted several days ago that CPI in 2010 would likely exceed 3 per cent, the official target. And the October increases may not be the end of the current inflation cycle given tighter food market conditions, accelerating wage growth and very loose liquidity conditions.

As to the level of growth, it is true that growth is moderating, evidenced by both monthly economic data released today and quarterly GDP growth data (down from 10.3 per cent in the second quarter to 9.6 per cent in the third quarter and possibly around 9 per cent in the fourth quarter). But most economists agree that the current growth slowdown is likely to be limited. The market generally expects GDP growth to stay at the 8.5-9.5 per cent range in 2010.

The term ‘marginal stagflation’ has been suggested by a government official during internal discussion. It refers to the situation when growth is decelerating but inflation is accelerating. This combination certainly complicates economic policymaking: should the central bank tighten or ease monetary policy? Fortunately, the People’s Bank of China (PBOC) already provided an answer to this question last night by hiking the reserve requirement ratio by 0.5 percentage points.

Clearly, then, inflation is the number one risk, at least for now. Because of the widespread labor-shortage problem, wages are currently growing at 20 per cent. New loans amounted to RMB 587.7 billion in October alone, and total new loans in 2010 are likely to exceed the RMB 7.5 trillion target set by the central bank. This follows a record of new loans at RMB 9.6 trillion in 2009. Although PBOC hiked the base deposit rate by around 25 basis points three weeks ago, today’s CPI data made the real interest rates even more negative. Wherever possible, money is chasing goods and assets madly. Prices of sugar, cotton, beans, apple and garlic are skyrocketing one after the other.

The Fed’s QE II (second phase of quantitative easing) may further complicate China’s inflation picture. To be fair, given the current condition of the US economy, there is nothing wrong with the Fed supplying a lot of money. In fact, quantitative easing has already had some positive impact on the US economy, by allowing for financial intermediation and pushing long-term bond yields. But it has produced two problems for the rest of the world. The first is that unfortunately the greenback that the Fed is printing is a global reserve currency. And the second is that, with a sluggish economy, close-to-zero interest rates, and expected depreciation, the US dollar is the best currency for carry-trade. So ironically, by adding massive liquidity to the global economy, the US may produce an asset bubble outside its borders. It is most likely that such a bubble would occur in the area of global commodities and/or affect emerging market economies.

There is nothing China can do to change the Fed’s decision. But China should try its very best to avoid becoming the victim of loose US monetary policy. My own reading from the latest policy changes is that the authorities have probably concluded that preventing the creation of a new bubble in China is of utmost importance. Since the beginning of the year, the government has already implemented two rounds of tightening policies for the housing market.

But the key policy changes have, and will continue to, take place in monetary policy, in the forms of currency appreciation, rate hikes and temporary capital account controls. The need for currency appreciation is well understood by now, although resistance remains strong. A stronger currency is necessary to avert a currency war and to rebalance the Chinese economy (internally and externally).

PBOC introduced the first rate hike on October 19. This was an important departure from its previous position of holding the interest rate unchanged when the currency is under pressure to appreciate. This previous position was motivated by a fear of attracting more hot money inflows. But this rate hike is critical in order to combat inflation and prevent asset bubbles. It is true that higher interest rate might attract capital inflows. But caps on asset prices, and other measures discussed below, should actually discourage hot money flows.

Finally, it is possible that the authorities may also adopt some temporary measures to control short-term capital flows. Such measures may fall into two areas; cracking down on hot money inflows (through current account channels) and restricting short-term capital flows (by imposing a reserve requirement or a Tobin tax). Some measures may be necessary in order to provide a stable market environment for gradual exchange rate adjustment and to deal with likely spillovers from the Fed’s QE II.

These restrictions are likely to be temporary since the government is determined to accelerate capital account liberalization over time.

Yiping Huang is professor of economics at the China Center for Economic Research at Peking University and in the Crawford School of Economics and Government in the ANU.