New Lunar Year, Same Rising Inflation

Story Highlights:

• The Chinese government raised one-year interest rates by 0.25% to slow rising inflation.
• There is both worry China's monetary tightening approach is too gradual and further rate increases may slow growth too much.
• Gradual tightening likely gives China time and room to gauge the effectiveness of the incremental changes and adjust as necessary.
• This year, investors will have to focus more on individual country drivers as opposed to more macro drivers that impact broader stock categories.

to Chinese astrologers, the prescription for the 2011 Year of the Rabbit is to take things slowly and cautiously. China's approach to inflation certainly fits this theme—for the third time since last October, the government raised one-year interest rates, but only by an incremental 0.25%. Chinese markets were relatively flat on the news, signaling this move wasn't wholly unexpected. More rate increases could be in store this year should inflation pressures press on. Indeed, Tuesday's rate rise was by some as a move by the government to show action against inflation ahead of forecasted ugly numbers for January.

The to-be-released January report will likely reflect an inflation rate pushed up by higher food prices, increased consumer spending, and a spike in loan growth. However, consumption and loan numbers may reflect cyclical patterns, as both tend to increase in the beginning of the year and ahead of the lunar new year holiday.

There seems to be a two-fold fear in China increasing interest rates this way. There's China's approach is too gradual and much higher rates need to be implemented right away. Conversely, there's rising interest rates might dampen growth and subsequently demand from commodities-hungry China. However, it's not in China's best interest socially to dramatically slow growth, meaning its appetite for oil and industrial metals will likely persist. Plus, other Emerging Markets (EMs) and the continued global economic expansion could make up for any slack in demand from China.

Additionally, China's gradual steps in tightening monetary policy could be a result of lessons from historical missteps. During the last bull market, the government tried regulating inflation with currency appreciation, higher interest rates, and bigger reserve requirements—all arguably less effective levers that reigning in loan growth quotas. But persistent inflation eventually led China to reign in loan growth quickly to get inflation back under control, ultimately hurting the economy. This time around, China started by decelerating loan growth (quotas increased by lesser amounts last year and this) and augmented that policy with higher reserve requirements and interest rates.

Gradual tightening likely gives China time and room to gauge the effectiveness of the incremental changes and adjust as necessary. Plus, food prices are, and today's higher prices might sharply fall depending on supply and demand forces.

As the Year of the Rabbit hops on, it'll be easier to assess the appropriateness of China's slow and steady approach to restraining inflation and decelerating loan growth. Our guess is China's economy continues to grow strongly in 2011. But remember, strong GDP does not necessarily translate to huge stock returns. This is a reminder that this year, after a few years of EMs moving largely in lockstep in terms of market direction, investors will have to focus more on individual country drivers that impact broader stock categories.