China's unexpected interest rate hike - contradicting earlier People's Bank of China (PBoC) signals of rate stability - could reveal an important policy shift. Instead of focusing on supporting growth, the policy now seems to be primarily targeting inflation.

The change cannot be explained by data, given the continued slowdown of GDP in the third quarter to 9.6 percent year-on-year (YoY); In September, industrial output growth fell sharply to 13.3 percent YoY; CPI inflation was relatively stable, inching up to 3.6 percent YoY, and is still likely to meet the 3 percent target for 2010.

Given such a backdrop, politics could be behind the tightening move. Such an interpretation is corroborated by the fact that it came a day after the Communist Party plenum ended, paving the way for new leaders to take over in 2012 and making decisions on the 12th Five-Year Plan.

We think it was decided that a smooth transition requires social stability, which is threatened by the popular perception of inflation running faster than official data suggests and by unaffordable housing as real estate prices are rising again.

Averting these trends requires much more than one hike. We believe that China is at the start of a tightening cycle, with another move of 25 basis points (bps) in the fourth quarter and two more next year.

The main short-term policy objective is likely to bring the real one-year deposit rate into positive territory, as this would limit incentives to switch savings into investments in equities and real estate. The rate has averaged 50 bps in the past 10 years, but even after the hike it is deeply in negative territory, at -100 bps. Another policy goal is probably to depress CPI inflation below 3 percent.

The PBoC is likely to have a relatively short time frame to accomplish these targets, which is estimated at six months. Given the likely decline in CPI inflation after October to 3 percent YoY by March 2011, another 50 bps is needed by the end of the six-month period to bring the real one-year deposit rate to positive territory. Hence, a 25 bps hike in December and another move in February are expected. The central bank is expected to pause thereafter as inflation should stay below 3 percent for much of next year. However, the tightening cycle will likely resume in the fourth quarter of 2011 as price pressures will likely rebound in the second half of the year.

To tackle asset price bubbles, liquidity conditions will need to be tightened as well. The recent 50 bps rise in the reserve requirement ratio could be made permanent, and open market operations are expected to become larger. Already on Thursday, PBoC allowed the three-month bill rate to jump 20 bps, matching the increase in its three-month deposit rate. Historically, PBoC bill rates have often increased in smaller steps, so a jump is a signal that policy makers will tighten money market conditions.

In order to control CPI inflation and asset prices, nominal rates will need to be higher in the medium term than they have been in the past decade. As the nation is increasingly able and willing to embrace a consumption model, this should end disinflationary trends in consumer goods, clothing and transportation.

Food and housing prices will likely see the strongest upward pressure. The former will be boosted by spending power rising faster than domestic and global supply, and the latter as owning a home is a priority for a growing proportion of the population. The scope for monetary tightening will be raised by the fact that actual inflation may be higher than official data is able to capture, and by the need to achieve higher real deposit rates to limit investment demand for housing. As a result, a secular trend towards rising nominal policy rates is anticipated over the coming years.

The author is senior economist/strategist for Fixed Income Markets Asia ex-Japan at Credit Agricole CIB. The opinions expressed here are entirely his own.

(HK Edition 10/22/2010 page2)