China’s headline CPI rose to 3.5 per cent year-on-year in August, up two-tenth of a percentage point from the previous month. And disaggregated data reveal that inflation is mainly about food prices. This is the reason why some officials argue that monetary tightening was neither needed nor effective. However, during the thirty years’ reform period, almost every major inflation problem (in 1988, 1993 and 2007) was initially caused by food inflation. So the monetary policymakers would not treat food inflation lightly.

The current momentum of inflation is already pretty serious. CPI rose by 0.6 per cent month-on-month in August, which can be translated into annualised rate of 7.2 per cent. This certainly is way above the central bank’s target. More importantly, the headline number is probably grossly underestimated due to under-represented service prices in the basket. Some economists put down a more realistic CPI reading at 5-6 per cent currently, compared with the official number of 3.5 per cent. The Ministry of Commerce collects market prices for agricultural food every week. These numbers confirm that food prices already rose during the past three month at annualised rate of above 30 per cent!

But that’s not all. Two more factors shadow outlook of China’s inflation picture. First, although loan growth is slowing, the total new loans will still exceed 7.5 trillion yuan, PBOC’s annual target.. This is about 50 per cent more than in a normal year. With negative real deposit rates, liquidity holders desperately look for opportunities to invest. They first pushed up stock prices and then housing prices. When these prices stabilised, they shifted their focuses on certain types of commodities, such as beans, garlic, cotton and sugar. As long as liquidity is abundant, some prices will rise rapidly.

Second, wages are rising by at a pace of 20 per cent a year. Economists and government officials still dispute the notion that China is rapidly approaching the Lewis turning point. But every business person in China agrees that it is happening: it is increasingly difficult to find additional workers and labor costs are skyrocketing. Increases in wages are actually a positive development for China today. It has already led to improvement in consumption and therefore should be good for rebalancing of the economy. But inevitably, it will be inflationary.

The rate hike on October 19 is not only an effort to combat potential inflation, it is also an important departure from the typical Japanese approach of fighting currency appreciation. In the months following implementation of the Plaza Accord, Japan lowered interest rates and increased money supply. The reason? To reduce pressure for appreciation and mitigate impacts of appreciation. That approach, however, caused an even more devastating consequence: an abnormal bubble, which eventually collapsed in 1989.

Some policymakers had a similar mindset in the early days: we could not hike the rate because it would exacerbate currency pressure. But they have been worrying about an asset bubble since the beginning of the year. The government already implemented a number of tightening measures toward the housing markets. Those measures, unfortunately, did not have much impact since they did not address the root cause of the bubble risk: liquidity. The rate hike on October is unlikely to lead to a collapse of the housing prices, which have potential to go up further in the coming years given healthy balance sheets for the households and banks. But the latest change in the mindset of government officials may be able to help China avoid major asset bubbles like those experienced by Japan in the late 1980s and by the US during the early years of this century.

There is a worry that the rate hike might lead to more inflows of ‘hot money’. This is probably true, given that all major central banks and those in Asia are in a pause mood, if not loosening mood. But if the rate hike adds downward pressure on asset prices, it may at the same time discourage hot money inflows. The net impact is not clear. But ‘hot money’ is not something the government can completely eliminate.

In the near term, it is probably safe for the government to allow the currency to continue to appreciate. With risks of a double-dip receding, the policymakers are probably more confident about the growth outlook. There is also a possibility that they may tighten controls over certain types of capital inflows in order to reduce ‘hot money’ flows. These, however, should be viewed as temporarily responses to volatile market conditions. The long-term trend of capital account liberalisation remains on track.

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.