China raised interest rates on Tuesday for the fourth time this year, aiming to counter expectations of accelerating inflation after consumer prices rose in July at the fastest pace in more than a decade.

The People's Bank of China (PBOC) increased the rate that banks pay for one-year deposits by 27 basis points to 3.60 percent, and the corresponding benchmark for lending rates by 18 basis points, to 7.02 percent from 6.84 percent.

The central bank said the increases, which take effect on Wednesday, were designed to reasonably control credit growth and to stabilise inflationary expectations.

Although the timing was a surprise, most economists had forecast an increase, both to calm growing popular unease over inflation and to encourage savers to keep their money in the bank instead of piling into the surging stock market.

The PBOC is concerned about falling real deposit rates spurring the flow of funds out of deposits into equities. We don't think this is a response to strong (economic) growth, said Ben Simpfendorfer, an economist with Royal Bank of Scotland in Hong Kong.

Even after the latest increase, one-year certificates of deposit badly lag the consumer inflation rate, which jumped to 5.6 percent in the year to July, the fastest pace since early 1997, because of a spike in the cost of pork, eggs and other foods.

Lin Songli, an analyst with Guosen Securities in Beijing, noted that the central bank had raised lending rates less than deposit rates, even though the economy expanded 11.9 percent in the second quarter from a year earlier.

By doing this the PBOC was signaling that the pace of growth was not its main concern. The move is mainly targeting inflation, and the authorities might have reached a consensus that investment growth is not a big problem now, Lin said.

INFLATION CONCERNS

Although non-food inflation eased to 0.9 percent in the year to July, policymakers are concerned that rising food prices are already rippling out across the economy.

Newspapers are full of stories of how the cost of everything from instant noodles to wedding banquets is rising fast -- in a country where inflation has triggered unrest down the ages.

Inflation in China is largely due to supply side factors, i.e. food prices which are not directly impacted by the monetary policy decision. But to the extent it may cause a rise in inflation expectations, it's pretty prudent of the authorities to act, said Dwyfor Evans, an economist with State Street Global Advisors in London.

This is not the end of tightening but depends on how much more inflation will rise, he added.

Qu Hongbin, HSBC's chief China economist in Hong Kong, agreed that the central bank was likely to tighten policy further, but he said it would do so primarily through open market operations and further increases in required reserves.

The PBOC will still keep policy tight, but going forward I expect the PBOC to probably rely more on quantitative measures rather than a rate hike, Qu said.

The central bank would be especially cautious about raising rates again due to the possibility of a cut in U.S. interest rates as a result of a spreading international credit squeeze.

If the premium of U.S. rates over Chinese rates narrows too much, speculative money could pour into China betting on a stronger yuan, giving the PBOC's money managers a fresh headache.

AGAINST THE TIDE

The Fed cut its discount rate last Friday and signaled that it is ready to lower the more important fed funds rate, the benchmark rate for overnight interbank loans, if the economic outlook darkens further.

Perhaps the most surprising aspect of Tuesday's rate rise was that China tightened policy at a time when central banks around the world are engaged in a concerted attempt to soothe rattled markets.

This is obviously going to inject further uncertainty into an already fragile situation, said John Kemp, an economist at Sempra Metals in London.

It's also a very blunt reminder that whilst the problem in the U.S. is an implosion of financial asset prices and the potential for a sharp slowdown in the second half of the year, in China the economy is still booming and inflation remains an issue. So if investors are hoping for co-ordinated interest rate cuts around the world, they may be disappointed, he added.

The yen trimmed its gains while euro zone and U.S. Treasury bonds rose in reaction to China's rate rise.

Guosen's Lin said he feared for the Shanghai share market, which is up 80 percent this year on top of a 130 percent leap in 2006. The stock market is going to tumble tomorrow, especially banking shares, he said.

China Inflation