High inflation, low inflation

China's central bank just announced a surprise increase of interest rates to help rein in the inflationary pressure.

It said it was raising benchmark rates by 25 basis points, taking one-year deposit rates to 2.5 percent and one-year lending rates to 5.56 percent.

Consumer-price inflation has already crossed above Beijing's 3% target for 2010. In August, the annualized rate was 3.5%.

Over here in the U.S., the opposite has been the case. The core consumer inflation rate is hovering around 1%, and maybe heading lower. In the face of slow growth, deleveraging, and high unemployment rate, this is alarming. Because the economy may be headed for deflation, when prices for goods and services are trending lower in general.

In other words, the economy is too "cold" in the U.S. and too "hot" in China. And higher interest rates in China may serve to attract even more hot money. On the other hand, the Fed's easy money policy would potentially add more liquidity to the world economy, much of which would find its way into China's asset markets, causing more inflationary pressure.

China has so far been quite successful in controlling credit expansion and contraction using adminstrative means, in order to maintain its currency peg to the US dollar. It's perhaps time to change that practice to help balance the world economy. A stronger yuan can help China take on more leadership role.