WE have long argued there is no room for complacency in monetary management in spite of moderating economic growth for six straight quarters. Despite the economic downtrend, asset prices have managed to defy gravity. The macroeconomic tightening program was somewhat successful in restraining investment-led growth and the ascent of asset prices. However, economic forces are back at work again, ramping up inflation risks over the medium term. This is in spite of the lower annual CPI target of 3.5 percent set at the National People's Congress. A holistic approach to the formulation of monetary policy will be beneficial to the long-run betterment of the economy. As such, interest rates must rise in China.

It is now clear that administrative controls on property transactions cannot hold the floodgates shut forever. On March 1, ahead of the National People's Congress, authorities had imposed a 20 percent capital gains tax for existing home sales in order to cool down the market. The ever-growing demand for property precipitated the surge of property prices, which in turn contributed to elevated inflation expectations.

If "real interest rates" are calculated alternatively as nominal deposit rates minus inflation of property prices (that is, deflating by housing prices instead of the CPI), it is easy to explain the solid demand for properties - real rates have been in negative territory for many years. From this perspective, monetary policy should be tighter than otherwise. The differences between conventional and alternative measures of real deposit rates are significant, which may lead to the central bank to draw different conclusions on how monetary policy should be conducted. At present, the central bank's bias leans toward tightening.

Wages are escalating nationwide. Although wage data are not published frequently, they influence inflation expectations just the same. In fact, expectations of future wage hikes amongst manufacturers remain high in spite of moderating growth. The persistent surge of wages is not only a reflection of declining surplus in young labor, but is also a direct result of the state's regulatory mandate to improve labor's income prospects over the medium term.

Price reforms in necessities such as water, electricity and fuel will also exert upward pressure on end-consumer prices. For instance, costs of medicine, private school tuition and transportation have been escalating in the past few years. Although they form a small portion of the CPI, the sum of these items makes up a large portion of household expenditure. In fact, the CPI merely describes the present situation of food and rental inflation. Although food prices are thankfully retreating from their peaks, inflation expectations on food remain elevated as the economic recovery gains traction. As for the residence component of the CPI, it is largely out of line with reality, because the rental market in China is actually quite small. Should authorities solely anchor monetary policy to the recent downtrend of the CPI, and cut interest rate and reserve requirement ratio in response, both the scale and magnitude of the asset bubble would rocket to unprecedented levels.

When the push for urbanization kicks in nationwide later this year, the pressure on prices will increase. China's urbanization rate is expected to rise to 53.4 percent by the end of 2013 from 52.6 percent last year.

Two approaches

Against this backdrop, interest rates in China must rise over the medium term. Of course, China can lift rates the conventional way - by altering benchmark rates. But the same outcome could be achieved via interest rate liberalization, which the central bank had restarted last year by raising the ceiling on the benchmark deposit rate and lowering the floor on the benchmark lending rate simultaneously. The experimentation last year confirmed that: (1) all banks raised deposit rates for fear of losing deposits to each other; (2) lending rates did not go down because of higher risk premium amid more stringent risk controls.

Finally, quantitative easing programs conducted by other central banks around the world increase the risk of capital inflows and a resultant boost in money supply.

Funds outstanding for foreign exchange at financial institutions increased by 683.7 billion yuan (US$108.5 billion) in January, even more than the whole of last year's 494.6 billion yuan, threatening to drive up inflationary risks. More importantly, this is the part of money supply that the central bank has little control over.

Even the domestic portion of money supply is increasingly difficult to be controlled as the growth of total social financing has quickened over the past year. Financial instruments such as trust loans and corporate bond financing saw much faster rates of growth than conventional yuan bank loans. That explains the constant worry over the proliferations of China's wealth management products. Real rates are too low, forcing liquidity everywhere for yields regardless of risks.

It is heartening to see that authorities have accounted for these inflation forces when formulating monetary policy. First, the central bank neither cut the reserve requirement ratio nor interest rates even at a time when the CPI was decelerating. Second, the central bank has increasingly used repo operations to control liquidity in the banking system. Third, the government has reiterated that administrative controls on the property market will remain. Authorities know well the considerable impact on property prices if the reins are cut loose.

Keeping vigilance

That explains why administrative controls on the property market will likely remain in place in spite of completion of leadership transition. Finally, the central bank has acknowledged in its latest Monetary Policy Report that "due to different factors, demand and supply curves will probably become steeper, making prices more sensitive to demand expansion," reflecting its vigilance against inflation over the longer run.

The medium-term outlook on China's interest rate trend is clear.

The central bank can either choose to raise benchmark rates or achieve the same result by deepening interest rate liberalization. Pursuing the latter route would be more consistent with China's desires to internationalize the yuan, which implies fewer controls over the capital account and the need for interest rates to be market-determined.