The price for soybean milk rose 40 percent in Shanghai lately, which has caused anger among the city's residents, according to local media reports. It would not be such a big deal if soybean milk was the only food item that had seen a price increase of late.

Unfortunately, none of the available data suggests that the recent price hike is unique to soybean milk. Of the 31 food item prices which are closely monitored by the government, approximately 80 percent recorded price increases in some 36 first- and second-tier cities on the mainland in October compared with September. As food becomes more expensive, the cost of living is also picking up accordingly.

Without doubt, inflation is a cause for concern among middle and low-income families, who spend a big portion of their family income on food - close to 50 percent for rural families.

Since the middle- and low-income earners are the most vulnerable to inflation, addressing their needs is a matter of great concern. It certainly would help if we had some measures in place to subsidize low-income earners when inflation increases beyond a certain level.

For China's economy - which has been overheating for quite some time - an inflation target of 3 percent is reasonable, and is also accepted as "a necessary condition" for interest rate increases. But to keep inflation from surging beyond the target level is not enough. More importantly, we should restructure the economy and use a tight monetary policy to prevent things from getting worse.

To ease inflationary pressures, interest rate hikes can always be seen as an effective tool in which to refer to. But the 0.25 basis-point hike recently adopted by the Central Government may be too minimal a change to cool down inflation. To turn things around, the interest rate increase has to be bolder. But this is unlikely to happen - at least in the near term - given China's current situation.

Monetary policy, foreign currency controls and foreign exchange rates are interconnected. One has to be linked to another to make the whole monetary system work. Given the de facto fixed foreign exchange rate of the mainland and the near-zero interest rate in the US, increase rate hikes, causing a wider interest rate differential, can only speed up hot money inflows, helped all the way by the loopholes in the mainland's currency control system.

The government is in need of an interest rate hike to combat inflation. But before that, a floating foreign exchange rate regime must be installed first. Here, contrary to what many people believe, floating the foreign exchange rate does not mean relaxing controls on foreign currencies. In order to reduce hot money inflows, the Central Government should tighten its controls, while adjusting the exchange rate.

If the Central Government is not prepared to adjust the foreign exchange rate, it then has to consider using fiscal policies, such as raising tax on state-owned enterprises to keep them from investing heavily in the red-hot property or resources sectors with their war chests of cash. Moreover, a real estate property tax could help to curb inflation by reducing the "wealth effect" caused by asset price rises.

Finally, we must improve the social security system, which will boost domestic consumption, and, in doing so, help offset the reduction in exports caused by exchange rate adjustment.

The author, a former investment banker, is currently the associate director of MBA programs at the Chinese University of Hong Kong. The opinions expressed here are entirely his own.

(HK Edition 12/08/2010 page2)