China's risky inflation offensive

    One central bank is sticking to its exit strategy, but hang on tight: Even optimists don't expect the ride to be silky smooth.

    China said Friday it will pursue a "prudent" monetary policy next year, after three years of aggressive money printing in the name of counteracting the global economic downturn.

    Jokes about the apparent contrast with Fed policy aside, the move shows the world's fastest-growing economy is shuddering at the prospect of surging consumer price inflation. It has been on the rise for a year and recently hit 4.4%. Chinese policymakers clearly remain worried as well about a large property bubble in hot coastal cities.

    But China's crackdown on easy money carries significant risks for a global economic recovery that is banking on strong demand from emerging economies. Should China hit the brakes too hard, the prices of stocks and commodities, to name two major risky asset classes, could be hit hard next year.

    Analysts at Goldman Sachs this week pronounced a so-called hard landing in China or other developing nations such as India and Brazil the second-biggest risk to their 2011 global growth forecast, after the sovereign debt problem stalking the euro zone.

    Goldman expects the world economy to grow around 5% in 2011, adjusted for inflation. It sees the price of oil soaring to $105 from a recent $89 and says U.S. stocks could rise 23%. But those numbers could go out the window if China's economy hits the skids after money gets tighter.

    "The possibility that EM tightening is delivered too bluntly or that the market loses confidence in the response is probably the biggest risk here, certainly for many cyclical assets," Goldman economists Jan Hatzius and Dominic Wilson said in a note to clients Wednesday.

    China's comments come a day after the European Central Bank delayed its own exit from easy money policies designed to keep the sinking European banks awash in liquidity. They also come as the Federal Reserve comes under political pressure for its plans to buy government bonds, which inflation hawks have attacked as less than prudent.

    China has spent recent months trying to quash potential asset bubbles in the property market by raising bank reserve requirements and through other administrative tools. But IHS Global Insight economist Xianfang Ren says Friday's move shows the race is on to quell troublesome food inflation.

    "The tightening message sent by the CCP politburo statement is clear and strong, suggesting that China could embark on a more broad-based tightening cycle going forward as inflation starts to spread from the asset market to goods market and from food to non-food items," he wrote in a note to clients.

    At the same time, a weaker-than-expected U.S. jobs number out Friday leaves open the possibility that the Fed may have go full steam ahead beyond the current $600 billion edition of QE2, the unpopular policy in which the central bank sops up government bond issuance by creating new bank reserves.

    More expansive Fed policy means more liquidity flowing into China and other emerging markets, potentially pressuring policymakers there to take stronger action to keep a lid on inflation – and leading to more of the trade tensions that have characterized the second half of this year.

    But the optimists say there is a good chance a gathering recovery will be able to shake off the inevitable bumps in the road.

    "We would not be surprised if markets have to deal with periodic turbulence around these issues, but we do not expect them to derail underlying improvements," Goldman said in its report Wednesday.