China: The new Alan Greenspan

chart_ws_currency_cny_usd.top.png By Paul R. La Monica, assistant managing editor


NEW YORK (CNNMoney) -- China's central bank raised interest rates Tuesday morning. And the market responded with a collective yawn. At first, stocks barely budged. Ditto for bond yields, oil and the dollar.

As the day progressed, stocks actually marched even higher.

paul_lamonica_morning_buzz2.jpg

So much for fears of global inflation running amok and worries about how emerging markets would be forced to tighten monetary policy.

Yes, I'm being a bit glib. Investors would be unwise to ignore what's going on in China. The fact that the People's Bank of China raised rates by a quarter of a percentage point to just over 6% is of course interesting.

It is the third such move in four months and comes at a time where Ben Bernanke's Federal Reserve is still keeping its benchmark rate near zero and the European Central Bank is leaving rates at 1%.

But the reason that investors may not be too terribly concerned by China's move to put on its interest rate hiking boots may be because the PBOC appears to be adopting an almost Greenspan-ian approach to tackling inflation.

Under Alan Greenspan, the Fed chairman formerly known as the Maestro, the Fed often referred to how it intended to raise interest rates at a "measured pace."

That phrase was interpreted by Wall Street as a signal that the Fed would simply boost rates one quarter-point at a time in order to not spook investors too much.

While the PBOC does not use similar such language in its statement, it seems as if China also does not want to get too aggressive with rate hikes.

"If there is one thing China is showing, it is that it does not want to do anything radical. It wants to take slow, gradual steps to fight inflation," said Axel Merk, president of Merk Mutual Funds, a Palo Alto, Calif.-based money manager specializing in currency investments.

The obvious negative of big sweeping rate increases is that it could slow lending activity, and thus economic growth, to a halt. Fickle traders also get nervous and the knee-jerk reaction to rapidly rising rates is often a nasty sell-off.

However, if inflation, particularly when it comes to food prices, is really such a big problem in China, then wouldn't it make more sense for the PBOC to stop mimicking Greenspan and emulate his predecessor Paul Volcker instead?

Volcker pushed rates up rapidly in the 1980s in an attempt to combat double-digit inflation. (So much for Gerald Ford being able to Whip Inflation Now!)

Of course, those were much simpler times for the Fed and central banks in general. You didn't have people scrutinizing every single word of Fed officials for hints about what the next policy move would be.

So it may not be palatable in 2011 for a central bank to even talk about boosting rates dramatically, let alone actually doing it.

But some fear China may be taking it too slowly -- and that the market may be giving China too much credit.

Investors may not be factoring in the possibility that China will eventually have to catch up with inflation, that is step on the brakes more forcefully to slow its economy down.

"There is this prevailing notion that China is an expert at managing its economy. That's ludicrous," said Quincy Krosby, market strategist with Prudential Financial in Newark, N.J.

Krosby said that emerging markets around the world are likely to keep raising rates in the coming weeks and months. She noted how inflation fears have propped up in other parts of Asia, such as Indonesia and India, as well as Brazil, Chile and other South American countries.

Merk agreed that more rate hikes are in the cards. But in the case of China, he said rate hikes are not enough. Fortunately, there is another solution -- letting its currency rise even more than it already has.

"What central bank has ever been accused of being ahead of the curve? That just doesn't happen," he said. "The only way to address inflation is to allow the yuan to appreciate more freely. China needs to learn to be more nimble."

That may be true. But China would probably be wise to also stop taking pages out of the Greenspan rate hike playbook. Sooner or later, the PBOC is probably going to have to raise rates a lot higher than where they are now.

China can't avoid the inevitable -- even if it means upsetting the apple cart that is the financial market in the short-term.

"Right now, investors are giving China a free pass and are expecting a soft landing," said Krosby. "But central banks typically have a problem engineering one."

-- The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks.  To top of page

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