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China’s central bank gaining credibility

China raised interest rates for the fourth time in less than six months in a fresh attempt to battle rising inflation. In a world flooded with easy money, especially the US dollar, fighting inflation won't be easy.  Food inflation is especially problematic since consumers in developing countries, like China, tend to spend a larger share of their expenditure on food. 

Despite the difficulty, economic history repeatedly shows once a country's central bank establishes itself as a credible inflation fighter, the country's economy, despite short-run fall, will win out eventually in the long run.  The finding is true also for stock market.

China's central bank, PBOC, so far has been the most aggressive central bank in raising interest rates. This is partly due to the fact that Chinese currency is still soft pegged to the US dollar.

Raising interest rate will cool down domestic economy.  However, it will promote further carry trade (or capital inflow) into China, heating up the economy, offsetting the policy goal.  This will happen despite China's tight capital control – profit seeking capital will always find its way into China, albeit the magnitude won't be so great as in the situation where no capital control is imposed.

Chinese policy makers, sooner or later, will realize they need to fight inflation using another powerful policy tool – currency appreciation.


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