China's factory inflation cooled in December as manufacturers expanded more slowly after a strong run in growth, lessening the need for the country's central bank to tighten monetary policy too far.

The official Chinese purchasing managers' index (PMI) edged down to 53.9 in December from November's 55.2, falling short of a median forecast of 55.5 in a Reuters poll of 12 economists.

The results of the survey of 820 firms will likely be welcomed by China's central bank by showing the world's second-largest economy was still growing solidly despite the slight pull-back in activity.

More importantly, they held out hope that China's inflation, running at their highest in over two years, may be peaking soon.

That should calm investors who are worried that accelerating inflation will lead China to aggressively tighten policy and hurt growth in the world's fastest-growing major economy.

Growth is not overheated, (and) the chance for inflation to be out of control is low, said Ting Lu, an economist at the Bank of America-Merrill Lynch in Hong Kong.

Policy will be tightened, but don't expect excessive measures.

The input cost sub-index in the official index fell to 66.7 in December from 73.5 the previous month. Although that is still well above the 50-point level that demarcates expansion from contraction, it showed prices were rising at a slower pace.

Hitherto accelerating inflation and record house prices have led China's central bank to signal time and again in recent months that the country needs prudent monetary policy to curb price pressures and prevent asset bubbles.

To match its tough rhetoric with deeds, the central bank raised interest rates on December 25 for the second time in just over two months. Market consensus is that it will increase rates twice more in the first half of 2011.

For some, that China can tighten policy at a time when the U.S. economy is still battling near-10 percent unemployment is a sign of the Chinese economy's strength.

Zhang Liqun, a government researcher at the China Federation of Logistics and Purchasing, which compiles the PMI index on behalf of the National Bureau of Statistics, said as much.

The growth of industrial output for November increased a little from the previous month, while export and investment rose strongly. So from this, it is not apparent that the economy is in a downward trend, Zhang said.

POLICY UNCERTAINTY

Inflation in China raced to a 28-month high of 5.1 percent in November and that has stirred discontent among its populace.

Anxiety over China's policy outlook in the face of rising prices have unsettled some investors and taken a toll on Shanghai's share index <.SSEC>. It lost 14 percent in 2010, ranking it one of the worst performers in the world for the year.

For China's top leaders, accelerating inflation is a headache. High prices can threaten their political leadership by causing social unrest, as they had in the past.

That has led the Chinese government to signal repeatedly in recent weeks that the task of reining in prices is among its top priorities for 2011.

China's central bank, which has no autonomy over monetary policy and needs approval from the highest echelons of power within the government on any rate move, has fallen in line with the policy goal.

Recent public commentary from the bank suggested it is ready to use a range of tools to curb prices and excess cash, seen as the main driver of inflation.

Measures the central bank said could be taken include further increasing reserve requirements on a differentiated scale, depending on the size of the bank, as well as lifting deposit rates to drain excess cash from the system.

Some investors have also speculated that it may allow the yuan to rise at a faster clip to rein in imported inflation.

(Reporting by Huang Yan and Koh Gui Qing, editing by Jonathan Thatcher)

China Inflation