Chinese consumer inflation unexpectedly slowed last month, but a leap in lending and a rise in factory-gate inflation will keep policymakers alert to the risk of credit-fueled overheating in the world's third-largest economy.

The dip in inflation, though likely to be temporary because of seasonal factors, gave a boost to markets on the hope that Chinese tightening need not be as aggressive as some had feared. Asian stocks rose, copper prices jumped and oil strengthened.

The central bank has already started to tap on the monetary brakes, notably by raising banks' required reserves, and economists expect further tightening steps in the months to come. This view was all but confirmed by the central bank later in the day, when it said in a report that it would normalize monetary conditions after last year's ultra-loose pro-growth policies.

The January CPI does mean that pressure on policymakers to do something right away is not there anymore. But we expect the February number to be close to 3 percent, certainly above 2, so pressure for a rate hike in the second quarter is very strong, said Tao Wang, an economist with UBS in Beijing.

The consumer price index rose 1.5 percent in the year to January, slowing from a 1.9 percent increase in the year to December and undershooting forecasts of a 2.0 percent rise,.

China's economic data at the turn of the year are tough to read because of distortions caused by the variable timing of the week-long Lunar New Year holiday, which fell in January last year and February this year.

The upshot was that food prices, which make up one-third of China's CPI basket, increased slowly in year-on-year terms last month but are likely to rise more strongly this month.

The central bank will probably have to wait until seasonal factors fade in one or two months to make further moves, said Jiang Chao, an analyst with Guotai Junan Securities in Shanghai.

GRADUAL TIGHTENING

In a quarterly monetary policy report, the People's Bank of China was as clear as it has ever been about the path of gradual tightening it has embarked on.

We have to reasonably normalize monetary conditions, returning from anti-crisis mode to an ordinary basis, it said. Other parts of the report -- about maintaining yuan stability and controlling inflationary expectations -- were largely repetitions of its statements over recent months.

The determination of China's Communist Party planners to keep a grip on the economy was evident in loan figures for January.

Bank lending of 1.39 trillion yuan was the third-largest monthly total on record. But, given that banks had already lent 1.1 trillion yuan by mid-January, the full-month total showed the success of subsequent arm-twisting to slow credit growth.

The government, with its very early action on direct control of credit, has been able to keep overall lending below last year's level, Wang said.

Banks lent a record 1.62 trillion yuan ($237.3 billion) in January 2009 when they heeded the party's call to pump up credit and revive an economy that stalled in late 2008 under the weight of the global financial crisis.

Banks went on to lend a total of 9.5 trillion yuan in 2009, providing the fuel for GDP to expand 8.7 percent, by far the strongest growth rate of any major economy. This year, Beijing has set a lower new-loans target of 7.5 trillion yuan.

INFLATIONARY RUMBLINGS

One unknown for policymakers is whether manufacturers and wholesalers will be able to pass on rising prices to consumers.

Factory-gate prices rose 4.3 percent in the year to January, accelerating from a 1.7 percent rise in the 12 months to December. Economists had expected a 4.2 percent increase.

There is no close link between the two inflation gauges in China, partly because of fierce competition and also because steady increases in productivity keep a lid on unit costs.

But some economists point to a combination of factors that could fuel consumer inflation.

Credit growth leapt 31.7 percent last year; minimum wages are rising in some coastal manufacturing provinces; and a resumption of fast economic growth may reduce spare capacity.

Goldman Sachs said this week that policymakers in Beijing would not tolerate an inflation level above 4 percent, while the China Business News identified 3 percent as the key level.

If inflation exceeds that level or if the Federal Reserve raises U.S. interest rates, the Chinese central bank could respond by raising its own interest rates or further increasing the proportion of deposits that banks must hold in reserve at the central bank instead of lending out, the paper said on Thursday.

The PBOC raised required reserves by half a percentage point last month, taking them to 16 percent for big banks and sparking a global markets sell-off on fears that China was slamming the brakes on an economy that has been a major force behind the global economic recovery.

Premier Wen Jiabao has said China will be paying more heed to month-on-month changes since year-on-year comparisons are distorted by the depressed state of the economy in early 2009.

In January alone, consumer prices rose 0.6 percent, following a 1.0 percent rise in December.

I don't think the central bank will introduce blanket aggressive tightening measures in the first half, especially since CPI was not as high as the market expected, said Nie Wen, an economist at Fortune Trust Co in Shanghai.

($1=6.827 Yuan)

(Additional reporting by Aileen Wang, Farah Master, Michael Wei and Sally Huang; Writing by Alan Wheatley; Editing by Ken Wills and Neil Fullick)

China Inflation