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Last week, news of China raising its interest rate by 0.25% barely moved the market. As reported by the Wall Street Journal, most analysts expected that there would be only one interest rate raise left in PBOC’s pocket this year. They reasoned that inflation would peak during the first half of 2011 and gradually drop in the second half largely due to a higher base.

These analysts might be too optimistic in their forecasts. The first thing that came to mind is a series news stories by both Chinese and English media on the National Development and Reform Commission (NDRC), a powerful economic planning body in China. Near the end of March, NDRC asked Chinese coal miners to keep the coal prices low, as coal is the major input for generating electricity in China. Then, NDRC urged Unilever (NYSE:UL) and other consumer goods producers to stop raising prices. A few days later, reports surfaced that NDRC had talked to 17 industry associations (apparently the petroleum industry is too powerful to be included in the 17 industries) to require their cooperation on stabilizing prices. The latest industry that was asked by NDRC to keep prices stable is the liquor and beer industry. Considering the negligible weight of beer price in CPI, one has to wonder about the implication underlying this piece of news.

There are several factors behind the current price surge in China. The end of Lunar New Year holidays and the end of annual meeting of the national congress meant that the previous price control measures largely expired. The disaster in Japan, not only pushed costs higher in the global supply chain, but also gave the Chinese financial system an excuse for NOT taking strong measures to drain liquidity facing the uncertainty. After the dampening impact of Japan’s earthquake on commodity prices quickly faded, prices of energy products, metals and agricultural goods spiked immediately. Dow Jones-UBS commodity index had risen by more than 4% since March 1, and increased by more than 8% since Japan earthquake. The latest Chinese import-export data showed that China’s import quantities and prices of iron ore, copper, soybean, grain and fertilizer all increased significantly from February. Much higher import prices of raw materials will no doubt further push up the inflation rate in China in following months, in addition to contribute to China’s first quarterly trade deficit in 6 years.

To rein in inflation, China relies on more than interest rate policy. Tools such as exchange rate, bank reserve requirement ratio, loan cap, interest rate and other price control measures are going to be used more intensively in the face of growing price pressure. Sectors, which are strongly affected by commodity prices and subject to price control measures, such as real estate, food processing and electricity generation, will become more vulnerable if China’s March CPI surprises the market on the upside.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: China's March Inflation: No Way to Go but Up