China’s central bank surprised the market on October 19 when it raised interest rates 25 bps in spite of a slowdown in GDP growth to 9.6% in Q3 from 10.3% in Q2. Given that the previous 2002-2007 cycle growth averaged 10.3%, China’s economy is nowhere near overheating. The fact is that monetary policy remains very stimulative with real rates below 2% at a time when inflation is again raising its ugly head.

It thus seems pretty clear that, barring a sudden and unlikely decline in inflation rates in coming months, China’s monetary authorities will keep ratcheting interest rates up towards the 4-5% real rate level. This will surely unsettle equity and commodity markets which will rightly fear a slowdown in China’s growth rate when Western economies continue to struggle. Furthermore, protectionism will return to the forefront as China will want to refrain from letting the renimbi appreciate while it is applying the monetary brakes.